Running head: ETHICS OF ACCOUNTING-THE CASE OF ENRON 1

Ethics of Accounting-The Case of Enron

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Ethics of Accounting-The Case of Enron

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Overview

Enron Corporation was one of the leading American energy company, which had its

headquarters in Houston, Texas. The company expanded its business strategies something that

saw it become very profitable (Nelson et al, 2008). Enron was praised for its business innovation

strategies and it was named by Fortune magazine as America’s most innovative company for 6

years in a raw beginning 1996 to 2001 when it was rocked by one of the biggest accounting

scandals in America. The company’s share price rose to the highest of $90.75 per share in 2000

however, I 2001, it was revealed that the company had been involved in accounting fraud which

involved hiding debts amounting to billions of dollars, the company shareholders filed a $40

billion lawsuit (Nelson et al, 2008). Its stock price decreased to $1 per share by the end of

November 2001 and it eventually filed for bankruptcy in December the same year that became

the largest corporate bankruptcy in American history. The paper explains what went wrong at

Enron and identifies who cause the problem. The paper also looks at the accounting

values/principles that were violated and who violated the values. The paper is concluded by

looking at what should be done differently to avoid the results that the public, employees,

shareholder experienced after the scandal.

Discussion

What Went Wrong and Who Is Responsible From an Accounting Perspective

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In 1992, Enron through the efforts that were made by the then CEO Jeff Skilling received

US Security and Exchange Commission (SEC) to use the Mark-to-Market (MTM) as an

accounting method. MTM is an accounting method that allows organizations to value their stock

based on the fair value of the organization’s assets. However, the fair value changes with the

changes in the market conditions. According to the case analysis, it has alluded that Enron used

this accounting technique to inflate its estimated profits and mislead the investors. The company

used Special Purpose Vehicles (SPVs) to get loans on behalf of the company as one way of

hiding its expanding loans (Cohan, 2002). Enron’s CFO and other top leaders at the company

hatched a fraudulent scheme, which used off-balance-sheet Special Purpose Vehicles, which are

also referred as the Special Purpose Entities to conceal its expanding debts and unwarranted

assets from the creditors and the investors.

The first thing that went wrong is that the company used Special Purpose Vehicles not to

generate revenue but to hide toxic assets and hide debts of the company. Secondly, SPVs were

used to hide company’s accounting realities instead of highlighting the operating results.

Similarly, another thing that went wrong is that Enron used its highly rated stock to the several

SPVs that it had formed a relationship with ad in exchange; the SPVs will give the company cash

or a note (Cohan, 2002). The company then allowed SPVs to use the company stock that it had

received to hedge an asset, which was listed in Enron’s balance sheet. The company also failed

when it had to guarantee the SPVs value for the stock as one way to reduce apparent

counterparty risk. The SPVs that the company used during its scheme to hide the accounting

realities was not illegal but the practice was illegal since the company used them through off-

balance-sheet.
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The other thing that was done wrong is that the SPVs were not used in the right way as a

debt securitization way, which posed a huge disaster to the company as the company capitalized

the SPVs with its stock. This ploy made it difficult for the SPVs to hedge Enron’s assets that

were listed in its balance sheet if the company’s share prices fell (Cohan, 2002). Similarly, the

company failed to disclose a conflict of interest it had with the SPVs and the stakeholders.

Although the company disclosed the existence of SPVs to the investors, the explanation given in

the company’s accounting results was limited and could not help the public and investors to

understand it. The company did a big mistake when it failed to disclose the non-arm’s-length

agreements that the company had entered into with the SPVs.

Several people were responsible for what went wrong at the company, which generated a

huge accounting scandal and subsequent collapse of Enron because of bankruptcy. From

accounting perspective, the first person who was responsible for the scandal is the company’s

CFO, Fastow. It was the idea of Fastow to introduce the scandalous off-balance-sheet Special

Purpose Vehicles scheme to hide the company borrowing and debt accounts (Li, 2010). This

scheme amounted to the violation of accounting best practices, which amount to non-disclosure

of accounting reports. This also amounted to a lack of transparency in disclosing of the

accounting reports, which violates the General Accepted Account Practices compliance

requirements.

Secondly, the other person who was responsible for the wrongs at Enron was the CEO of

the company. As the person who is responsible for making major decisions, the CEO must have

agreed to the scheme by Fastow to introduce off-balance-sheet SPVs that were used to hide the

company’s expanding debts (Li, 2010). Similarly, CEO is not only the public face of the

company but is also bestowed with the responsibility of protecting the rights and interests of the
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shareholders in the company. In this regard, the CEO failed to adhere to this requirement as the

CEO colluded with the CFO to defraud the shareholders.

Another person who should be held responsible for the scandal at Enron is Arthur

Anderson. Arthur Anderson LLP was the accounting firm for Enron at the time the scandal

occurred. Arthur Anderson was among the five leading accounting firms and was praised for its

high standards, quality risk management, and reputation (Li, 2010). The accounting firm gave the

company accounting report a clean bill of health despite the company’s poor accounting

practices.

Key Values and/or Principles of Accounting That Were Violated

With the changes in technology that is used in public accounting, organizations have to

be very keen and careful with how their corporate accounting is done to avoid accounting

scandals. The case of Enron is not in isolation some more cases of the same accounting fraud

magnitude have been revealed since then. Corporations have to ensure that their accounting

information is assembled and reported in a more objective way (Yarahmadi & Bohloli, 2015).

The information must be free from any form of inconsistency and bias, which may be deliberate,

or from human errors. Based on the analysis of Enron accounting fraud, it is very clear that the

people responsible to assembling and reporting accounting information of the organizations

violated several accounting principles that are enshrined in the General Accepted Accounting

Principles (GAAP).

To begin with, it is apparent from the case of Enron that the principle of regularity was

violated during the accounting processes. The principle of regularity, which is also defined as the

principle of conformity, requires the accountants and the auditors to observe all applicable
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accounting laws, regulations and rules when assembling and reporting financial information of

the company (Yarahmadi & Bohloli, 2015). This includes observing the rules that are outlined by

the US Security and Exchange Commission regulating financial reporting by the publicly traded

companies and the regulations that have been outlined by American Institute of Certified Public

Accountants (AICPA) and Financial Accounting Standards Board (FASB) regulations.

Another accounting principle that was violated at Enron was the principle of sincerity.

The Chief Finance Officer who provides directives to the accountants working in the accounting

unit heads the accounting unit in a corporation (Duska et al, 2018). The principle of sincerity

requires that the accounting unit reflect in good faith the real financial situation of the company

and report it as it is on the ground. In the case of Enron, Andrew Fastow who was the CFO used

off-balance-sheet Special Purpose Vehicles to hide the debts that the company had incurred

which compromised the company’s true financial report.

The principle of non-compensation is very important when it comes to corporate financial

reporting. The accounting unit is required by this principle to disclose all the details of the

financial accounting information and avoid compensating a balance sheet item with the other.

From the analysis of the Enron accounting fraud, it is very clear that the Chief Financial Officer

at Enron violated this principle (Duska et al, 2018). In reality, the CFO was compensating debts

with assets of the company. The company allowed SPVs to hedge Enron assets that were listed

on its balance sheet and get cash or a note from them in exchange. This amounts to replacing a

loss with a revenue.

For any publicly traded company to be compliant with the SEC regulations and rules

pertaining to financial reporting, the company has to comply with the accounting principle of full
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disclosure. This principle requires that all financial information that is important to investors,

shareholders, and lenders be disclosed fully to the public to see (Duska et al, 2018). Accountants

are required to disclose such information through the financial statements or in the appendix or

footnote section of the financial statements. Analysis of the Enron case clearly indicates how

CFO Andrew Fastow used SPVs to cover-up some of the company debts. This cover-up is a clear

sign of non-disclosure that was perpetuated by the CFO in collusion with the CEO.

The value of integrity is very important element a professional accountant or certified

public accounting firm should value. The value of integrity requires that the accounting firms be

honest, forthright, and candid with the financial statements of the client. Accounting firms should

restrict themselves from gains and advantages using client’s information (Duska et al, 2018). The

firms should not be involved in taking advantage of the client to manipulate client’s information.

It is expected that public and private accounting firms should have established a code of ethics

for accountants, which will ensure that the company employees act in a more professional

manner. However, this was not the case with Arthur Anderson LLP, which was Enron’s

accounting firm. Although the company’s accounts were poorly assembled and reported, the

company went on and approved them without considering the established standards that were

supposed to be met.

Arthur Anderson was expected to review the accounting statements and give its opinion

on the professionalism of the financial statements. Similarly, Arthur Anderson violated the value

of independence, which is a very important ethical value for any accounting firm can embrace.

The accounting firm was expected to give its honest opinion after reviewing the company

financial statements but this did not happen as it only endorsed what the company had presented

to the firm for auditing (Yarahmadi & Bohloli, 2015). Similarly, as the CFO of Enron, Andrew
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Fastow was not independent as he allowed the CEO to influence his decisions and dance to the

tune of the CEO in matters assembling and reporting financial statements.

What Should Have Been Done Differently To Avoid the Negative Outcomes Experienced By

Stakeholders?

Although accounting, assembling, and reporting of financial statements may prove to be

complex in some instances, they are some of the organizational processes that can be executed in

a more professional manner if the rules, standards and laws regulating the processes are

followed. Enron could have avoided the financial scandal that rocked it if the company could

have implemented employees’ code of conduct that outlines ethical requirements that employees

must observe when executing their mandates (Duska et al, 2018). Organizations are required to

establish and implement an internal code of conduct that will outline the way its employees will

conduct themselves while at work. The code of ethics should set standards that employees should

meet when executing their mandates. If this could have been the case at Enron, the CFO could

not have violated the GAAP standards in relation to assembling and reporting financial

statements.

Although Enron’s scandal was the biggest in American accounting fraud history, it was

not the first one in history. In this regard, several accounting factors result in financial reporting

failures, lawsuits, fines, and penalties. It is important for organizations to learn from the mistakes

of other organizations so that they can avoid becoming a victim in the future. The company could

have avoided the outcomes that affected the stakeholder negatively if it could have learned from

organizations that failed before it (Duska et al, 2018). The stakeholders could not have

experienced these outcomes if Enron had implemented a strong code of conduct for employees
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that require them to undergo ethics training and put in place a policy that will control top

leadership’s level of involvement in business transactions. This could also have been avoided if

the company could have implemented a business code of conduct and ethics that will ensure that

the board of directors, executive officers and other senior financial and business officers stick to

the procedures and rules that are enshrined in the code.

It is the dream of every organization to hire honest employees; however, the company

would have avoided the fraud if it could have developed a formal hiring routine. The company

board of directors did not execute its mandates effectively. The board could have developed a

policy that will allow the board members to conduct background checks on all staffs dealing with

bookkeeping and accounts (Duska et al, 2018). Organizations are expected to scrutinize the

eligibility of the employees in accounting unit as the financial muscle of the company increases.

The fraud could have been avoided if the corporation could have maintained an internal control

framework, which is aimed at preventing and detecting any form of fraud. Restricting access to

financial data, inventories, and establishing a multi-person sign-off is one way of curbing fraud

in companies.

Conclusion

Enron was praised for its business innovation strategies and it was named by Fortune

magazine as America’s most innovative company for 6 years in a raw beginning 1996 to 2001

when it was rocked by one of the biggest accounting scandals in America. The first thing that

went wrong is that the company used Special Purpose Vehicles not to generate revenue but to

hide toxic assets and hide debts of the company. Secondly, SPVs were used to hide company’s

accounting realities instead of highlighting the operating results. Similarly, another thing that
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went wrong is that Enron used its highly rated stock to the several SPVs that it had formed a

relationship with ad in exchange; the SPVs will give the company cash or a note. The company

then allowed SPVs to use the company stock that it had received to hedge an asset, which was

listed in Enron’s balance sheet. Some of the principles that were violated include integrity,

disclosure, non-competition, and sincerity. The scandal could have been avoided if the company

could have established and implemented an internal code of ethics that regulate the way

employees execute their tasks.

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References

Cohan, J. A. (2002). " I didn't know" and" I was only doing my job": Has corporate governance

careened out of control? A case study of Enron's information myopia. Journal of Business

Ethics, 40(3), 275-299.

Duska, R. F., Duska, B. S., & Kury, K. W. (2018). Accounting ethics. Wiley-Blackwell.

Li, Y. (2010). The case analysis of the scandal of Enron. International Journal of business and

management, 5(10), 37.

Nelson, K. K., Price, R. A., & Rountree, B. R. (2008). The market reaction to Arthur Andersen's

role in the Enron scandal: Loss of reputation or confounding effects?. Journal of

Accounting and Economics, 46(2-3), 279-293.

Yarahmadi, H., & Bohloli, A. (2015). Ethics in Accounting. International Journal of Accounting

and Financial Reporting, 5(1), 356-360.