The Enron scandal of 2011 revealed that the Federal government’s accounting and auditing regulations of Fortune 500 firms were lax at best. The fact that one of the largest accounting and auditing firms at the time was an active participant in the scandal illustrated the need for additional industry oversight. Andersen was the accounting firm that was responsible for auditing Enron’s financial statements. The accounting firm failed to call out Enron on discrepancies and questionable accounting practices that overstated Enron’s earnings and understated its debt (Cross & Kunkel, 2012). This showed that generally accepted accounting practices or GAAP also need to be examined. GAAP may be too complicated for many to fully understand and its complications may indeed be opening up loopholes for inaccurate financial reporting. Ultimately, the Enron scandal revealed that auditing of financial statements by a third-party is not a guarantee of accuracy and it is the ethics of a firm (e.g. its senior leadership) that determine whether accuracy is embodied by its employees.
Enron’s bankruptcy was caused by inconsistencies in the company’s financial reports (Cross et al., 2012). A company’s public financial reports include an annual statement of earnings, statement of cash flows, and a balance sheet. Enron chose to create subsidies that on paper brought in additional equity and simultaneously incurred additional borrowing. This act allowed the company to underreport its debt, which in turn overinflated the company’s earnings (Cross et al., 2012). By creating other companies, Enron was able to deflect the true financial state of the parent company and minimize the true nature of its debt. The more debt a company has, the less financially solvent it is. In other words, Enron was able to conceal the fact that it was cash poor. Enron was simply not as liquid as its financial managers wanted investors and the markets to believe.
Accounting and Auditing Practices
Andersen, the public accounting firm in charge of auditing Enron’s financial statements, failed to question Enron’s reported financial activities (Cross et al., 2012). It was Andersen’s role to ensure that Enron was reporting the truth on its statements. The accounting firm chose not to make Enron revise its statements by eliminating the separation of the company’s debt and equity into separate subsidies.
The ethical environment at both Enron and Andersen that led to fraud was one that put the bottom line ahead of everything else. Enron was concerned with falsely inflating its profits in order to cause an increase in its stock price. An increase in the company’s stock price meant the company was able to falsely generate more capital or an influx of cash. As one of Andersen’s largest clients, management at the accounting firm was also solely focused on revenue, regardless of whether that revenue was based in true earnings. Neither firm was concerned about the public investor and whether Enron would be able to fulfill its financial obligations to shareholders.
According to the article, the impact of Enron’s bankruptcy was favorable for its competitors. Enron’s competitors were able to capture the failed company’s market share. On average, firms in the same industry that were not audited by Andersen were able to gain 2.5 percent of market share within the first seven days following Enron’s bankruptcy announcement (Cross et al., 2012).
Importance of Auditing Process
The Enron/Andersen scandal illustrates the strong need for a meticulous auditing process. In all likelihood some employees of Andersen questioned and noticed the inconsistencies in Enron’s financial statements. It was up to the superiors of these employees to behave ethically, but these superiors chose not to – either as a result of pressure or an absence of morals. Although the Federal government has implemented tougher regulations in the wake of the Enron/Andersen scandal, it is ultimately individual and corporate ethics which drive the process. It is more important to be accurate and truthful than to attempt to mislead others for personal or corporate financial gain.
Cross, Joann Noe, & Kunkel, Robert A. (2012). Andersen implosion over Enron: an analysis of the contagion effect on Fortune 500 firms. Managerial Finance, 38(7), 678-688.