Abstract
The report intends to provide information and possible indications on the courses of actions that Enron took. As indicated, for a regular company specific accounting elements that Enron possessed may reflect negatively on the price of its shares in the Market. However, the reputation of Enron overshadowed these factors. The financial engineering inherent in the financial structure of Enron paved a path that will inevitably lead the company to ruins. The use of special purpose entities (SPEs) were among the company’s foremost financial tool in the market. Seen as a stable and law-abiding company prior to the collapse, Enron did comply with the necessary disclosure measures. The accounting firm tasked to monitor the financial disclosure in Enron was Arthur Andersen. In the context of capital market research, the efficiency of the markets is taken into consideration. Another issue that has affected the capital market research is reflected by the financial reporting of the companies, specifically the internal control of the organization. The structure of the board has considerably been instrumental in the provision of information and asymmetry of information in the market. In the case of Enron, information asymmetry indeed existed. As indicated in the earlier parts of the report, the employment of SPEs and other financial engineering is part of the grand plan of Enron to present a stable position in the market.
TOC \o “1-3″ \h \z \u I. Introduction
II. Shares in the Enron Setting
A. Non-adjustment on the Share Price of Enron
1. Complex financial structure
2. Off-balance sheet entities
3. Lack of disclosure
4. Lack of credibility of Andersen’s certification
B. Enron and the Market Behavior
III. Board Structure of Enron
A. Importance of Information Asymmetry of an Organization
B. Information Asymmetry in Enron
IV. Executive Option Grants
A. Efficiency Perspective
B. Opportunistic perspective
V. Imperfectly fashioned incentives and the lack of self-restraint: Containment and Resolution
VI. Conclusion
VII. References
I. Introduction
The environment of corporate governance has never been the same after the fall of corporate giant Enron in the early parts of the new millennium. Fundamental factors that essentially constitute corporate and organizational operations have been affected significantly on this occurrence. This study intends to provide an analysis on the on the circumstances surrounding the fall of Enron. The discussions on this research is going to be made with reference to theories of accounting and other elements of corporate governance that inevitably involved in the fate of Enron. The report intends to provide information and possible indications on the courses of actions that Enron took. This will provide a representation on how the experiences of Enron and possible outcomes from such actions could be averted in the future. Similarly, this study intends to establish the effectiveness of the existing standards to which corporate governance and accounting are founded. Discussions on the shares, board structure, executive option grants and the general perspectives on the situation on Enron are going to constitute the bulk of the paper. Past and existing literature regarding the situation on Enron and those related to accounting theories will be employed to support the claims that these discussions provide. At the end of the paper, a conclusion will be formulated based on the discussions and arguments made in this paper.
II. Shares in the Enron Setting
The facts presented in the background of Enron indicate that there are specific situations where the company had taken steps that may have significantly affected the price of its shares. As indicated, for a regular company specific accounting elements that Enron possessed may reflect negatively on the price of its shares in the Market. However, the reputation of Enron overshadowed these factors. This part of the study will take into consideration the reason for the non-adjustment of the share price of Enron and the consequent effects on the market behavior after the fall of the company.
A. Non-adjustment on the Share Price of Enron
Despite the changes and rather complicated situation in which Enron have taken prior to its collapse, the share price that it had in the market have not been adjusted to suit the weakening position of the company. The following discussions will take into consideration the reason why this may have taken place.
1. Complex financial structure
The financial engineering inherent in the financial structure of Enron paved a path that will inevitably lead the company to ruins. The structure of Enron is peppered with all sorts of financial arrangement that turned out to devour itself when the company got stuck in a corner. The use of special purpose entities (SPEs) were among the company’s foremost financial tool in the market. Enron have worked with several SPEs before it claimed for bankruptcy in 2001. (Fusaro and Miller, 2002, 34) The engineering involved in the financial structures of the company, through the use of these SPEs in some ways circumvented some common disclosure principles that were necessary. One specific detail in this context is the booking of revenues of Enron before actually selling the products as manifested in their purchase of Blockbuster.
To put is simply, the use of SPEs were the easy way for Enron to maintain the share price of the company. (Fox, 2003, 63) The demands in which traditional and legitimate means to normalize the growth of the shares in the market so as to create capital for the company and to sustain its favorable position in the market may have been overshadowed by the appeal of the SPEs to the corporate managers. To illustrate, reducing the cost of capital may affect specific operations of the company like the expenditures that involved the perks that these corporate managers may have been currently enjoying. In engineering the financial structure of the company like collaborating or creating an SPE, all the top level management requires is the commitment of their circle on the management of earnings acquired or otherwise. This means that the company must, in some way, have the top level employees (board of directors and senior management) to work together such that the approval of such complicated financial structures as that of Enron would be approved.
2. Off-balance sheet entities
As it is discussed above, the use of SPEs creates an opportunity for the corporation to create financial transactions and its consequent effects without having to worry of it being reflected to the balance sheet and other financial statements of the organization. One reason why companies use SPEs is to securitize the loans they acquire from other entities. (Benston and Hartgraves, 2002, 245) In this manner, the SPEs borrowing of the funds from other entities would not reflect on the balance sheet of the sponsoring entity. Nonetheless, an entry pertaining to the costs of the employment of the SPE would only be present in the financial statements, not the debt and payables acquired through these SPEs. Thus, these entities are able to hide the debt of companies such as Enron. This means that though Enron may in fact took the appropriate measures prescribed by pertinent accounting standards, its use of SPEs has allowed them to circumvent disclosure of the debt. This indicates that the company appears to still maintain its financial position in the market given the fact that investors and other interested buyers of their shares are unaware of the huge amounts of debts they have incurred through the SPEs.
Another thing that these SPEs did for Enron is to allow the said company to hide its poor-performing assets. (Benston and Hartgraves, 2002, 245 Any bad investment may be shifted on the hands of these SPEs to paint an appealing picture of the sponsor company to the general market. In the case of Enron, the transfer of poor-performing equity investments given to a broadband services provider in these SPEs allowed the said company to turn a deaf ear when these investments were subjected to decline caused by sudden changes in the market.
3. Lack of disclosure
The background of the company indicated that there were lapses in the monitoring of the board of directors. Corporate disclosure is an important instrument of accountability for directors to the shareholders of the organization. According to the work of Baums (2002, 6) the use of corporate disclosure takes on a facilitating function for particular members of the organization: investors, creditors, regulatory agencies, and the general public. The problem on the part of Enron is that they painted this façade of a well-conforming corporation to the stakeholders and the public in general. Only the top level management was aware of the actions taken by the company in employing entities such as SPEs and the like. Theoretically, the board of directors of an organization is employed by the shareholders to take into consideration specific elements of the operations of the organization. (Andjelkovic, Boyle, McNoe, 2002, 1) This means that the shareholders of the organizations have instilled their trust to these individuals to steer their company towards a better position in the industry. In the case of Enron, the management provided this picture of stability that the shareholders’ initiative to look into the affairs of the company even the financial position has been mitigated. Suspicion on the apparent lack of disclosure has not been seen with malice.
In addition to that, Baums (2002, 11) noted the importance of materiality of the information disclosed. The problem in the case of Enron is that the top management and the board of directors are the ones who decide what to disclose to the public. Seen as a stable and law-abiding company prior to the collapse, Enron did comply with the necessary disclosure measures. However, they failed to provide total disclosure to their shareholders. The use of SPEs helped present a positive image for the company with very negligible doubt that it was doing some underhanded actions to keep their head above water.
4. Lack of credibility of Andersen’s certification
The accounting firm tasked to monitor the financial disclosure in Enron was Arthur Andersen. According to the facts presented, the credibility of the said accounting firm was compromised due to the inadequate level of control as well as the undermining of the independence of the firm’s function in the company. Apparently, the accounting firm, aside from its conventional commission on helping and assisting the firms like Enron with their finances, it also provided the company with consulting services. The cross-selling of the consulting services placed a greater power on the part of the client in the Enron-Andersen relationship. This undermines the credibility of the accounting firm for the reason that the outcomes of their independence from the client. Andersen, with the offering of the additional services, may present some level of favor towards its client to continue availing the consulting services that the accounting firm offers. The problem in this matter is the fact that the client now holds some sort of leverage to its accounting partner. They possess the capacity to terminate the consulting services of the accounting firm thus posing a loss on the part of Andersen. (Fox, 2003, 158) To some extent, the provision of consulting services from the accounting firm places them in a level similar to a management position in the organizational structure of Enron. Having such a position in the organization could not help but instill in the accountants and auditors of Andersen to appear to have biases in favor of Enron making their certifications dubious.
B. Enron and the Market Behavior
In the event that strapping corporations such as Enron comes to its knees and eventually met its demise, there are certain aspects of capital market research are left hanging for question. Needless to say this area has been greatly affected by the conducts carried out by Enron. In the context of capital market research, the efficiency of the markets is taken into consideration. The playing field in which Enron operated rested on the supposition that a strong and stable market is capable of maintaining itself provided that proper and appropriate information is provided. In the case of Enron, they have provided information that appeared to be unbiased. In the end, this information was eventually found out to be misleading. There goes the issue on whether the appropriate or what appears to be correct information is enough to predict the actual financial position of a company. In this context, changes on the criteria of what is considered “correct” information may be taken into account. Enron presented that one could make information public and in the same time withholding the data which could reflect a bad image for the financial position of the company.
Another issue that has affected the capital market research is reflected by the financial reporting of the companies, specifically the internal control of the organization. The changes made by the American government to the legislation pertaining to the market provided a considerable discrepancy with the rest of the world. The changes indicated the Chief Executive Officer (CEO) and Chief Financial Officer’s (CFO) obligation to certify the financial statements of the company. A substantial change in this matter is manifested in the requirement of “fairness” as opposed to mere compliance to the accounting principles of the financial statements. A further issue to be resolved in connection to this is the effectiveness of the existing accounting principles used all over the world.
III. Board Structure of Enron
In the area of corporate governance, the structure of the board has always been considered as among the important indicators of how an organization will fare in the market. A study of Daily and Dalton (1993, 65) indicated that those that compose and make up the directors have a significant effect on the performance of the organization. Moreover, a study of Certo, Daily and Dalton (2001, 33) indicated that the composition of the board also indicate the possible value of the company, especially in instances of IPO. The structure of the board has a significant effect on the overall performance of the corporation. This is especially true in the context of Enron. The structure of the board has considerably been instrumental in the provision of information and asymmetry of information in the market. The discussions below are going to discuss market concepts like information asymmetry in the market and how it affected the conditions surrounding the case of Enron.
A. Importance of Information Asymmetry of an Organization
Information asymmetry is a concept in economics that signifies a level of lopsidedness in the available information. Specifically, the information that parties involved in a transaction holds considerable power when time of bargaining comes. On a conventional note, the seller frequently has more information about the product than the buyer. Nevertheless, one could not discount the possibility that the buyer could have the necessary amount of information that could be considered higher than the buyer. This characteristic of the information present in the transaction are often used as tools in instances where breaches arise in the agreement.
There are several models of information asymmetry that are present in the existing literature. These models are classified into adverse selection models and moral hazard models. In the former, one party is ignorant of important information as the agreement is taking place. The latter on the other hand depicts an uninformed party that doesn’t have the information about the performance of the transaction and doesn’t have the means to react in instances of breach.
In the context of the stock market, the regulatory bodies provide standards and principles of disclosure such that the playing field is considerably fair, meaning that the information provided by the sellers may sufficiently be used by the buyers to deduce the value of buying a share or a stock. In the context of adverse selection, the individuals who are aware of an encouraging price will commence with the trade if they believe that there is an above-average probability that the odds are in their favor. (Zelinsky, 2004, 114) In the same manner, if they tend to see an irregularity or some indication that the price of the stock is not worth trading, acquisition of a trading advantage is in order.
In the context of moral hazard, it contributes to market failure because of the actions taken by one of the parties in the transaction. (Beddoes, 1999, 16) This is a concept provided to the increased risk of possibly dishonest behavior. In this context, the party who caused the predicament could have the possibly of not suffering the entire penalty or negative consequences provided by the action. In some cases, they actually gain from these actions.
B. Information Asymmetry in Enron
In the case of Enron, information asymmetry indeed existed. From the structure of the financial backbone of the company, the balance sheet and even to the accounting firms that handled their finances. They played the stock market with such deceit that they mislead investors in buying their stocks. As indicated in the earlier parts of the report, the employment of SPEs and other financial engineering is part of the grand plan of Enron to present a stable position in the market. This reflects the adverse selection models indicated above. Enron have indeed presented the information required of them by the accounting principles and required disclosures as stated by the stock market, however, they did withheld certain information about their SPEs.
In addition, the actions taken by Enron were deliberately dishonest to gain the favor of the shareholders and possible investors. As seen in this manner, the actions done by Enron suffice to equate both adverse selection models and moral hazard models. With the two models manifesting in the actions of Enron, market failure is bound to be their fate as seen in their collapse in 2001.
IV.Executive Option Grants
The use of stocks as an incentive to managers has been one of the innovations on corporate compensations in the recent years. However, the case of Enron generally indicated that the use of these grants as incentives has been considerably been damaging to the corporation. The following segments will be discussing the said issue using both efficiency and opportunistic perspectives of the positive accounting theory.
A. Efficiency Perspective
In the case of Enron, the use of stock option as an incentive intended to solve the apparent principal-agent dilemma in the corporation. (Hake, 2005, 595) Specifically, the intention was to make the executives of the firm work doubly hard to maximize the value of the investors of the company considering that they are in fact shareholders themselves. It made the decisions made by the top level employees become radically analyzed in such a way that it should border from risk neutral to risk averse behavior.
The problem in the case of Enron is that the stock option offered was outrageously high considering that the company was “apparently” at the top of its game. The executives become leaned towards fraud and became risk-preferring. The company inevitably became a hedge fund. The executives were making decisions as they were gambling despite the rather uncertain nature of the ventures. The sole intention at this point is profit. Given the state of the executive options offered by Enron, a single small increase in the shares of the company will make these executives richer by several percentages. At this point, the human condition known as greed has taken over.
B. Opportunistic perspective
The provision of the said stock option plans were to be considered in the long term perspective. (Hake, 2005, 595) The growth of the corporation is the basic goal of the provision of stock options. However the case of Enron indicated a sense of short term profit on the part of the executives. This triggered the inevitable spiraling of the company.
An illustration of this long term growth is manifested in the fact that using stock option as an alternative compensation for the executives, it could therefore be used as a tool to improve the financial image of the company. Reductions in the costs and remuneration of these top level management personnel will be reflected in the financial statements of the firm. (Griner, 1996, 134) In the case of Enron, it acquired reductions on taxable income. (Hake, 2005, 600)
V. Imperfectly fashioned incentives and the lack of self-restraint: Containment and Resolution
Superficially, the reasons and attitudes following the decisions and occasions pointing towards Enron’s collapse seem uncomplicated. With it is individual and shared insatiability born in an environment of corporate conceit. Barely anybody sought to consider the corporation with skepticism. So, for a moment, almost not anyone did. Several continued purchasing shares. For the time being, the corporation made a lot of risk-preferring arrangements, a number of of which were external of the company’s usual asset risk control procedure. The corporation’s lack of transparency in exposure its financial concerns, subsequently by financial restatements revealing billions of misplaced liabilities and shortfalls, egged on its fall.
Consistent with conventional economic analysis, regulation of Enron was redundant for the reason that Enron, similar to other rational actors, would of its own accord act sincerely so as to lessen long-term costs of collecting capital, and its officers would not spoil their budding careers by partaking in financial fraud. Flawed operating choices could trigger a number of Enron’s problems. But it seems that a major part of the culpability for the collapse may possibly be as a result of the ethical atmosphere in the organization, which permitted a chain of ethical mistakes to take place. The accounting and security scam that brought about the Enron scandal originates itself in ethics. Its top-level personnel seem to fail to show any ethical concerns. Notwithstanding Enron’s commitment to ethics and obvious consideration to obedience controls, its perceptible ethical actions seem to have failed its decreed ethical objectives. It is in this manner that this study claims that matters of ethics are matters in which could only be controlled and not solved. Once unethical actions are done, little could be done to rectify it. Thus, containment and could only be done.
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