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Enron And Business Ethics: Financial Events

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Question:

Discuss about the Enron and Business Ethics for Financial Events.

 

Answer:

The financial events of the business world and accounting scandals have raised questions about the accounting practices many times. Business ethics are more in theories rather than in actual accounting practices. In this context, the present discussion is on energy giant Enron and off-balance-sheet financing. The company Enron was dealing in electricity and natural gas in the energy industry. It used to provide the broadband services and the financial products related to energy. But the company evolved from the field of energy to hedge fund and high-risk investments. In the year 1999 with its new vision of creating financing vehicles, it was into off-balance sheet financing. The company was declared bankrupt on December 2, 2002. The current essay is about what is off-balance sheet financing, how it works and why it matters. The concept of business ethics and the ethical side of off- balance sheet financing by the company is also discussed. Sincere efforts have also been put to explain the practices of off- balance sheet financing by the company in the light of the concept of business ethics and its importance to corporate governance.

The off-balance sheet financing is an accounting method by which certain assets and liabilities are recorded in such a way that they do not appear on the balance sheet. There are so many economic events or transactions which cannot be recognized in the financial statements as GAAP doesn’t qualify them as accounting assets or transactions. The types of off-balance sheet financing are as follows:

  • Operating lease
  • Take-or-pay contract
  • Throughput arrangements
  • Commodity-linked bonds
  • The sale of accounts receivables
  • Joint ventures
  • Investments

As the case was in Enron, there were special purpose vehicles (SPVs) or special purpose entities (SPEs). The ownership position was purchased by the companies in these SPEs. These SPEs maintain their separate balance sheet. The assets or liabilities of the companies are then placed on the balance sheet of the SPEs. The credit rating may be high in these SPEs than the firms sponsored them. But this helps SPEs to avail finance at a cheap rate. Enron used off-balance sheet financing to maintain financial covenants. This kind of financing is useful in case of preserving borrowing capacity, lowering the rate of borrowing and thus handling risks. Enron had a bad reputation for this kind of practices (MCAE, 2002).

The off -balance sheet financing is such a practice that its appearance in the financial statements as a footnote can easily mislead its users (MCAE, 2002).As Enron stated, a footnote in the financial statements regarding this kind of off-balance sheet financing arrangements is very important as per the Securities and Exchange Commission (SEC) and Generally Accepted Accounting Principles (GAAP).The companies need to disclose this kind of information to the investors. The GAAP also has laid down particular rules to record this kind of financing items. But awareness regarding these matters is not much to the stakeholders (Goergen, 2012). The Enron chapter was bad enough to make these regulatory bodies think over the standards and its guidelines related to the accounting practices.

 

Here, the background of business ethics was closely related with the leadership mechanism in Enron.  A sound business practice always makes an ethical approach. The respect, integrity, communication and excellence, all were included in the Enron’s ethics code.It was also stated in the Enron’s code of ethics that the employee shall always work for the best interest of the company without deriving any separate financial gain pertaining to the employment (Novak, 1996).But the violation of ethics and laws resulted in the collapse of Enron dramatically and eventual bankruptcy. The culture of the company has also affected the ethics of its employees. The high expectation of the company also demanded its managers to act in an unethical manner for nearest gain and that was reflected in the group behavior. The culture of arrogance made the employees of Enron believe that they were capable of handling more and more risk without any difficulty (Mallin, 2011). Ethics of respect and integrity were undermined due to company’s focus on decentralization and indulging employees by appraisals and compensation. The root causes of the Enron’s collapse were leadership failure and the culture of the company that supported unethical behavior to achieve numbers (Manoharan, 2011).

As per business ethics, the corporate balance sheet should give the accurate picture of the financial condition of the company. But in Enron, the books of accounts were cooked in such an unscrupulous manner that even after disclosure of transactions as per GAAP in footnotes; it was hard to capture the alteration of the image. Nowadays, the disclosure requirements are made very strict regarding off-balance sheet transactions. Still, the creditors are not always attentive towards these kinds of activities (Sims & Brinkmann, 2003). The Enron chapter revealed that the individuals in the organization need to be more accountable and ethically aware so that they do not indulge in structuring financial transactions deceitfully. The financial managers need to communicate the economic substance behind the financial transactions to comply with GAAP (MCAE, 2002).

But business ethics can also be tricky. The accounting practices which are perfect from legal aspects and widely practiced can be unethical at the same time. The regulatory bodies also need to think of the ways to enforce the standards better. The economic objective of the standards should be made very clear and should require the firm to disclose the intention behind the accounting practices they adopt. The standards should be made easily understandable to ordinary people and investors (Earley & Kelly, 2004). Ethically, it is the responsibility of the board and especially the audit committee to verify that the company is projecting and communicating the true fact regarding its financial position and financial transaction (Lander & Auger, 2008).

The corporate governance is also connected deeply with ethics. The corporate governance states that the company policies, customs, and laws to its employees should function from ground level to management level. The main aim is to create accountability. Here, the Business ethics plays a very vital role in corporate governance (Lander & Auger, 2008). The necessity of a solid corporate governance is always argued giving the example of bankrupt employees and stakeholders of energy giant Enron. The principles of corporate governance include:

  • Shareholder recognition and participation
  • Recognition of Stakeholder interests
  • Clearly outlined Board responsibilities
  • Ethical behaviour
  • Business transparency

There were ethical issues that directly hit the corporate governance of Enron. The elements of ‘law of diminishing control’, ‘ cognitive dissonance’, ‘group cohesion’, ‘confirmatory bias’ and the ‘the false consensus effect ‘ were found to block the flow of information in the company. The officers were found to hide the actual information deliberately by reporting the superiors inappropriately (Bartlett & Glinska, 2001). There was also irrationality in decision making. The senior management was not into the proper monitoring of conduct at the operational level. The individual subgoals were not in line with the overall goal of the organization as well. The adverse information was being transferred to the senior management (Lubatkin, 2009). Hence, the ethics and laws were not followed due to the intimidation. The employees were reluctant and also not having the courage to question senior management in case of any doubt. There was also a major problem of over-optimism in the organization (Fernando, 2009).The corporate governance is highly important for any company to prevent fraud, scandals and the liability of the company related to it, either civil or criminal. This builds the clean image of the company so that it is responsible and worthy of stakeholder’s trusts.

The companies need to realize in depth that business ethics are very important to get absorbed in the system. The reasons are many. An ethical vision of the company considering the interests of all the stakeholders ensures its sustainability (Douma & Hein, 2013). The sustainable long-lived profits are always better than short-lived profits with high risk. The company with the support of the corporate governance operates ethically and play safe from a behavioral risk perspective. It also prevents the anti-capitalist sentiments within the organizations. The business world needs to understand that the resources are limited on the planet and the population is growing. If these resources are depleted by unethical manner for purely individual gain, the current and future generation would have to pay a very high cost (Douma & Hein, 2013).

The code of ethics of Enron based on respect, integrity, communication and excellence was of little help to its corporate governance. It failed to create an ethical environment in the company. The ethical collapse eventually resulted in the collapse of Enron. The corporate governance is dependent on the proper state of mind of people involved in the organization and their sole acceptance to it. It should not be just a list of rules and guidelines for them that they would intentionally or skillfully ignore. Above all, the company should be responsible for protecting the interests of all its stakeholders and should act accordingly. The top management should percolate the ethics based corporate governance from tip on toeing. Then only this kind of scandals can be avoided in the future. 

 

References

Bartlett, C. A., & Glinska, M. (2001). Enron’s transformation: from gas pipeline to new economy powerhouse. Harvard Business School, (301-064).

Douma, S & Hein, S. (2013).  Economic Approaches to Organizations. London: Pearson

Earley, C. E., & Kelly, P. T. (2004). A note on ethics educational interventions in an undergraduate auditing course: Is there an “Enron effect”?. Issues in Accounting Education, 19(1), 53-71.

Fernando, A C. (2009). Corporate Governance Policies and Principles. Oxford University Press

Goergen , M. (2012).  International Corporate Governance. Prentice Hall.

Lander, G. H & Auger, K. A. (2008). The need for transparency in financial reporting: Implications of off-balance-sheet financing and inferences for the future. Journal of Accounting & Organizational Change, 4(1), 27-46.

Lubatkin, M.H. (2009). One more time: What is a realistic theory of corporate governance?. Journal of Organizational Behaviour,  28(2), 59-67

Mallin, C.A. (2011). Handbook on International Corporate Governance: Country Analyses. Edward Elgar Publishing.

Manoharan, T.N. (2011). Financial Statement Fraud and Corporate Governance. The George Washington University.

Sims, R. R., & Brinkmann, J. (2003). Enron ethics or culture matters more than codes). Journal of Business ethics, 45(3), 243-256. 

MCAE. (2002).  What Really Went Wrong with Enron? A Culture of Evil. Retrieved May 12 ,2017 from https://www.scu.edu/ethics/focus-areas/business-ethics/resources/what-really-went-wrong-with-enron/

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