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Enron Company: Effect of Financial Disclosures Research Paper


Introduction

Organizations use financial reporting as the primary tool for communicating the extent of their performance growth to their stakeholders. Reporting plays a considerable role in investment decision-making processes since it provides a reliable framework for analyzing an organization’s performance. Investors demand access to information that can aid them in determining the uncertainties of both current and future business cash flows.

Such availability of information helps them to evaluate firms, hence enhancing their capacity to make crucial decisions such as the selection of securities portfolios. As such, the degree to which organizations disclose their information may determine their performance and growth in their respective lines of business. Information disclosures ensure that all stakeholders make decisions that support a firm’s operations.

Currently, there exists minimal literature concerning the relationship between an organization’s disclosure policies, requirements for compulsory disclosures, and security analysts’ generated information. However, as the paper argues, despite such challenges, disclosures remain valuable in enhancing a firms’ financial performance. The case of Enron will be used to substantiate this claim based on the consequences that the company suffered following its failure to disclose its financial information to investors.

Literature Review

A wide body of literature on the effects of disclosures on financial performance focuses on its role in reducing information asymmetry (Shim, Cho, & Lee, 2016). According to Schöndube-Pirchegger and Schöndube (2017), accounting information is critical in the decision-making processes of different organizational stakeholders. For example, creditors and/or shareholders use the information in making decisions concerning a company’s capital commitments.

Based on the anticipated returns, disclosures happen following a firm’s evaluation of the potential investment opportunities. Upon the move by a company to make capital commitments, Asay, Elliott, and Rennekamp (2017) reveal how accounting information becomes the tool that investors use in monitoring the manner in which the entity uses such financial resources. Young (2014) argues that information asymmetries and agency problems that occur between firms’ managers, entrepreneurs, and investors explain the endogenous development of such information. Managers have more information on firms’ anticipated performance, which they may fail to fully share with shareholders or investors. Hence, they introduce an asymmetry that may comparatively disadvantage the shareholders.

Therefore, according to Asay et al. (2017), disclosures help in informing investors about profitable business lines and portfolios, which when tapped, may increase a firm’s financial performance.

Agency, capital need, institutional, and signaling theories constitute important tools for discussing how disclosures contribute to increased firm’s financial performance. An agency relationship entails “a contract under which the principal engages an agent to perform some service on their behalf involving delegating some decision-making authority to the agent” (Xi & Yang, 2016, p. 942). From the perspective of a firm, managers are the agents while the shareholders are the principals. In this affiliation, information asymmetry entails one of the main issues that impair the capacity of principals to have full gains in terms of ensuring that organizations fulfill their (principals) interests.

Insiders possess more information advantages compared to outsiders. Consequently, shareholders (outsiders) encounter the disadvantage of being unable to accurately evaluate and analyze the quality or value of decisions made by insiders (managers) (Asay et al., 2017). This situation creates the possibility of agents engaging in actions that are consistent with insiders’ personal goals without considering their responsibility to act in a manner that delivers value to the principals. Therefore, the issue of the need for negotiating contracts emerges as an important mechanism for preventing such conflicts of interests that result from selective disclosures (Bianchi, Corvino, Doni, & Rigolini, 2016).

According to Xi and Yang (2016), voluntary disclosure entails one of the best approaches to the application of agency theory in a firm. Indeed, through it, agents can guarantee ardent communication with principals to the extent that they can provide reliable, credible, and transparent information about a firm’s operations and performance in the market. Hence, voluntary disclosure can help in optimizing a firm’s value. Such information includes the existing and emerging investment opportunities and financing policies. However, agents may fail to disclose such information in the attempt to satisfy their interests.

Therefore, shareholders remain unaware of the market dynamics and opportunities. Arguably, such practices contradict or prejudice shareholders’ interests. For example, Jankensgård (2015) argues that non-disclosure or failure to divulge important market information leads to an increased capital cost, which translates into a reduced value for investments. Hence, faithful application of the agency theory reduces the possibility of information asymmetry by encouraging higher levels of voluntary disclosure, hence enhancing a firm’s performance.

From the context of the signaling theory, signals consist of agents’ reactions to the concerns of information asymmetries. Organizations react to these signals through the provision of information whereby firms present themselves as trustworthy with the view of experiencing minimal possibilities of being invaded by regulatory authorities, which seek to enhance corporate governance. Such immunity helps in making a distinction between better performing firms and non-performing ones. Hence, the signaling theory suggests that agents who engage in voluntary disclosures have a high public loyalty (Xi & Yang, 2016).

Therefore, their shares have higher demands, which increase a firm’s financial performance. However, the witnessed increased share demand due to companies’ disclosure of their financial information may not necessarily explain their fiscal performance.

According to Binh (2012), the institutional theory emphasizes the need for ensuring compliance and strict adherence to various external norms and rules. The public, different interest groups, and regulatory bodies encompass some of the entities that are interested in a firm’s financial performance. Indeed, Binh (2012) argues that companies engage in social contracts with members of the public to ensure strict conformity to institutional norms. The theory strengthens bonds between a firm and its owners. Therefore, it mainly applies to non-financial disclosures such as forward-looking and strategic initiatives.

The capital need theory regards the desire to raise wealth as an important incentive that pushes managers to engage in voluntary disclosures. Indeed, Bianchi et al. (2016) assert, “managers who intend to make capital market transactions have motivations to disclose information voluntarily to decrease the information asymmetry problem and thus decrease the external financing cost” (p. 189). In other words, through voluntary disclosure, managers develop the capacity to decrease the cost of a firm’s capital through the reduction of investors’ uncertainties.

Bianchi et al. (2016) support this assertion by adding that accurate information disclosures increase the liquidity of stock markets with the outcome of minimizing equity capital costs. This goal is accomplished following the reduced transaction costs and/or higher demand for a firm’s shares (Mangena, Li, & Tauringana, 2016). Therefore, from the capital need theory, businesses that engage in higher or full disclosures are likely to receive high stock price ratings, which form an important parameter for determining their financial standing.

Brief Discussion of Financial Disclosures

Financial disclosures are divided into voluntary, mandatory, and analyst reporting. Voluntary disclosure models suggest that financial transparency is not only important but also critical in ensuring information dissemination within an organization. Milost (2013) reveals how different models suggest the need for considering the balancing action in determining the thresholds for disclosure. An example of voluntary disclosures entails the cost model, which calls for disclosure determination. In other words, managers disclose information if it is adequately favorable since they must trade-off the cost of unfavorable disclosures, especially the momentous overheads (Milost, 2013).

Other examples of voluntary disclosure models include the indecisive rejoinder from investors, probabilistic information, and non-certifiable revelation frameworks. Despite the fact that managers are not pushed to divulge information under voluntary models, they must weigh both the implications of the disclosure and non-disclosure to their respective businesses.

A firm may fail to reveal information that it considers unfavorable to shareholders. Hence, developed capital markets have information admission regulations that call for mandatory disclosures. The directives include the balancing of the welfare of different organizational stakeholders. Disclosures heighten the benefits of some organizational stakeholders while decreasing those of others. According to Popa, Bogdan, and Balaciu (2012), such a normative understanding of mandatory disclosure explains the inexistence of one particular model of its analysis.

Indeed, literature only documents various rationales behind the need for the mandatory disclosure regulations coupled with the inevitability of various disclosure standards. Such underlying principles include financial externalities, real externalities, economies of scale, and agency costs (Popa et al., 2012). Political discourse perhaps explains well the need for mandatory regulations on accounting information revelation. For example, the process of developing the FASB and Securities and Exchange Commission (SEC) guidelines is open to political pressures. Such political strain manifests itself during the implementation of accounting standards.

According to Chen, Jung, and Ronen (2017), analyst reporting entails the third approach to financial disclosures. An example of this disclosure is the sell-side approach in the context of analysts working for brokerage agencies, bodies that conduct self-determining studies, and those working for investment-banking organizations. In such disclosures, analysts must make decisions concerning the necessary information to produce, when and whether to conduct reporting reviews, the kind of reports to produce or give out, and/or the level of availing disclosure documents that disclose or are in accord with the forecasters’ perceived beliefs on the operations of firms (Milost, 2013).

Analysts’ choices present the possibility of information exposure. They have incentives that compel them to ensure strategic communication in a less synchronized environment. Such enticements include increasing analysts’ reputation, optimizing the level of their targeted audiences’ reaction to reports, and the optimization of forecasts’ value. Forecasts are imperative when contextualized from an investor’s perspective since they (investors) are the major consumers of the financial information (Cheng & Ho, 2017).

Benefits of Financial Disclosures on Financial Performance

It is crucial to note that the contribution of disclosures to enhancing a firm’s financial performance only makes sense if managers observe and/or comply with the principles of corporate governance (Karpoff, 2012).

Firms may engage in various activities that reduce their disclosure levels or ensure that the divulged information does not reflect their accurate state of financial performance activities. For example, in the attempt to attract more external financing, companies may reveal overrated earnings in their annual financial statements. Such businesses suffer from increased costs of their capital, especially when SEC reveals such manipulations.

All companies strive to increase their capital while enjoying low operations costs (Bianchi et al., 2016). In other words, the desire to increase external financing constitutes an important motivation for engaging in earnings manipulations. Even though a firm may enjoy low capital costs after manipulating its financial statements, such benefits are short-term.

Hence, in the long-term, Mankin, Jewell, and Rivas (2017) assert that companies are better off disclosing accurate information while ensuring that no asymmetries are reflected in their operations, whether on a contract basis or not. In fact, devotion to the set contractual terms advantages an organization since it gains social support, reputation, and the acknowledgment of its authenticity. Reaping from these benefits requires an organization to disclose fully non-misstated financial information.

A business that operates in the modern economy should comply with the requirements of accountability imposed through legislation or regulatory bodies such as SEC. Indeed, when a company clearly and reliably discloses data on its financial performance, it establishes a good relationship with various regulatory bodies and investors (Asay et al., 2017). Hence, the move benefits it by preempting potential governments’ inquiries and fines that are associated with corrective actions, which may raise mistrust among shareholders. Such conformity with the laid down disclosure principles enhances business profitability.

Disclosure seals avenues and loopholes for acerbating corporate financial scandals. The past two decades have been marked by rising regulatory actions aimed at enforcing corporate governance. In some situations, governments have deployed regulatory bodies to target suspicious managerial practices. According to Mankin et al. (2017), one of the principal purposes of disclosures is to supply ardent financial information on a company’s performance to internal and external organizational stakeholders. However, from the owner’s perspective, cases of breach of corporate governance impair the benefits of financial reporting and disclosures.

For example, the issue of billions of dollars lost due to false statements raises doubt concerning the benefit of disclosure in terms of curtailing financial scandals. However, according to Mangena et al. (2016), financial statement audits coupled with regulations and laws focus on enhancing the credibility and quality of financial disclosures, hence helping investors to make quality judgments about a company’s performance.

Financial performance disclosures provide financial stability. Jankensgård (2015) posits that retaining information via non-disclosures has dangerous outcomes on a system’s stability. Hence, if all information relating to market security serves a public good, it should then be availed to all concerned parties. However, disclosures should provide benefits to organizations. For instance, suppose an organization discloses information about a future market’s performance trend, even though it is unlikely to occur. Some investors can interpret this data as bad news. Here, heightened transparency exposes the performance stability of a firm to risk.

Nevertheless, fraud-immune companies ensure full disclosure in compliance with the (Generally Accepted Accounting Practices (GAAP) and legal provisions such as the 2002 Sarbanes-Oxley Act (Young, 2014). Such conformity enhances the reputation and ratings of the respective companies in stock markets, a situation that results in high customer loyalty and market share. Proper financial operations in a company spare it the possibilities of penalties from regulatory bodies that investigate issues concerning the embezzling of funds. In other words, accurate disclosure has the benefit of increasing shareholders’ confidence in the capacity of a business to use equity capital in a way that generates positive returns.

Consequences of not Having Good Financial Disclosures on Financial Performance

Private companies have no legal requirements for disclosing their detailed financial performance information. Hence, they enjoy the freedom of choosing the kind of information to divulge. In fact, according to Thompson (2012), small companies may internally decide on who receives their financial and operations information rather than putting it in the public domain for scrutiny.

However, publicly traded businesses should comply with the disclosure laws and regulations applicable to areas such as financial performance, management compensation, and operations results. Small companies that choose to raise their capital by trading in shares must also comply with the majority of the disclosure regulations and laws. In the U.S., SEC has the mandate of enforcing disclosure principles. Having disclosures guidelines implies that any non-compliant business has to face the corresponding consequences (Mankin et al., 2017).

As Sepinwall (2015) asserts, some unethical managers may breach corporate governance principles by engaging in malpractices such as monetary overstatements in their reporting to the extent that an organization appears healthy while it is indeed suffering from massive losses and poor market capitalization. Such poor financial disclosures on a firm’s financial performance attract fines and penalties. An organization may create an impression of full disclosures while it has ideally disclosed inaccurate information due to unethical practices that include earnings mismanagement. Alternatively, it may choose not to fully disclose its financial information to its owners, thereby creating information asymmetries.

These two practices contravene the SEC’s disclosure laws and regulations in publicly traded companies. According to Beneish, Lee, and Nichols (2013), manipulating earnings violates the 1934 SEC Act. Publicized allegations on manipulated earnings make businesses experience severe consequences in terms of capital markets performance. While this consequence may only affect the shareholders through reduced financial performance, it underlines the need for legal actions against insiders who fail to comply with the laws and regulations on full disclosures.

SEC takes actions against all companies that violate financial reporting rules as established in the SEC Act of 1934. Through various Accounting and Auditing Enforcement Release (AAERs), SEC publishes its actions against businesses that violate the Act (Beneish et al., 2013).

Non-compliance compels SEC to bring legal actions against non-conforming companies. In fact, every year, through its enforcement wing, SEC, “brings hundreds of civil enforcement actions against individuals and companies for violating securities laws or regulations” (Felsenthal & Loffreno, 2017, p. 345). The wing acquires evidence on alleged violations from various sources, including market inspections, media intelligence, and self-regulatory agencies. It then uses the information in bringing civil actions before federal courts on behalf of SEC. Where businesses are found guilty of non-disclosure, it prescribes actions such as penalties and fines using the necessary laws.

A proof of failure to comply with disclosure laws and regulations as established and enforced by SEC has severe consequences. Once a firm has been found guilty, including the fact that it was involved in a lawsuit challenging its non-compliance with SEC’s applicable laws, it suffers a substantial decline in its stock prices. Besides, it not only experiences high capital costs but also incurs losses associated with regulatory and official penalties, which contribute to suboptimal financial performance. However, the extent to which a business experiences negative consequences depends on the enforcement ability of the regulatory bodies.

Poor enforcement ability implies that a firm can fail to comply with disclosure requirements and yet get away with it. Fasterling (2012) supports this assertion by observing that agencies that deal with disclosure play the role of disciplining non-compliant companies by enhancing transparency in their reporting, thereby triggering the development of norms, which define the level of interactions between them and their owners. The author emphasizes that regulatory bodies are less empowered to deal with non-disclosures. Therefore, companies can easily fail to divulge fully their non-compliance with financial performance disclosure laws.

However, Karpoff (2012) emphasizes that the recognition of non-compliance issues affects negatively the perception about a firm, especially among parties such as investors and consumers who do business with it, thus triggering high loss of business value. Hence, whether proved or not, disclosure noncompliance has financial performance implications to a company that is alleged to contravene the applicable laws.

Following the previously reported accounting frauds, SEC and political classes led by President Bush recognized the need to supplement or enhance the agency’s fraud surveillance and response mechanisms through the 2002 Sarbanes-Oxley Act. According to Chen and Huang (2013), the Act helps in curbing deception in publicly traded organizations. Before the enactment of the Sarbanes-Oxley Act, investors in the U.S. suffered from various fraudulent crimes, which led to the misappropriation of billions of money.

With the onset of many frauds that were reported in America, Senate Banking Committee held various hearings on the challenges encountered in the American financial markets, a situation that culminated in the disappearance of huge sums of money. During the hearings, the committee heard several complains, which led to the establishment of several causes of fraud, for instance, accountants’ insufficient supervision and ineffective disclosure guidelines (Felsenthal & Loffreno, 2017). The committee was convinced that any policy framework for curbing frauds should reflect these concerns in its formulations. Indeed, the failure to have good disclosures on a company’s financial performance exposes it to the consequences of breaching the Sarbanes-Oxley Act.

Enron’s Case of Non-disclosure

Enron, which was an American energy organization, became bankrupt in October 2001. The company had misrepresented its financial accounts to woo investors without their knowledge that it was already sinking into financial troubles. The 1990s technology bubble came on promising bright future for Enron. Previously, the company looked into transforming the energy business segment and the Internet by engaging in bandwidth trading (Di Miceli da Silveira, 2013).

Indeed, the market declared Enron as the real transformer. By early 2001 (during its peak), Enron’s stock prices dominated the market. In some situations, it reported over 90 USD per share, a figure that fell to about 1 USD towards the end of 2001. Again, its market capitalization leadership was unquestionable then. It stood at about 66 Billion USD. Hence, Enron was a clear leader in the new economy (Di Miceli da Silveira, 2013). Nevertheless, this perception only lasted for a while. A wave of accounting frauds damaged its reputation. Indeed, no other company has ever fallen from a dominant corporate giant to a total non-operational business within a short time as Enron.

The dawn of 1987 was a nightmare for managers at Enron after discovering that two of its oil traders had breached the code of ethics (Di Miceli da Silveira, 2013). Without taking due diligence to notify the company’s headquarters, based in Houston, the agents, Tom Mastroeni and Louis Borget, opened an account at Eastern Savings Bank. Despite arguing that this account was for business purposes, Mastroeni also had another one in the same bank under his name, which the parties had transferred 2 million USD from the business revenue.

When tasked to explain why such misappropriation happened, they informed Kenneth Lay (the then Enron’s CEO) that they wanted to surreptitiously engage in two major derivative business transactions (Di Miceli da Silveira, 2013). They explained that such a move would ensure that profits generated within one quarter would be reported during the second quarter. However, in this explanation, Lay found that the dual had also manipulated bank statements. Nevertheless, Enron’s Oil Trading Unit reported a profit of 10 million USD in the financial year of 1985 followed by 28 million USD the following year (Di Miceli da Silveira, 2013).

Comparably, initially, the parent firm was immensely struggling financially. In 1985, it reported a loss of 79 million USD. However, the trading unit indicated a positive financial performance of the company in 1985. In 1987, Tom Mastroeni and Louis Borget again came into a spotlight. Enron was facing an enormous mountain of losses amounting to one billion USD from Borget oil Trading. This situation would force the company to close due to bankruptcy. However, Mike Muckleroy (Enron’s administrator) worked down the losses to 140 million USD (Di Miceli da Silveira, 2013). Despite the problems encountered by Enron, Lay remained interested in the trading business. Compared to pipeline and the energy production units, it required less capital.

In 1990, Kenneth Lay hired Jeffrey Skilling as a McKinsey-based consultant (Di Miceli da Silveira, 2013). In the capacity of an advisor, Skilling devised what was to become the next important Enron’s business strategy. Instead of producing oil, Enron would use suppliers’ skills that would ensure that natural gas reached the market at the lowest price.

This plan sounded appealing. Therefore, Lay brought Jeffrey Skilling to work in full time at Enron as the expert to help in implementing the newly promising business approach. In the same year, 1990, Lay had also hired Andrew Fastow (Di Miceli da Silveira, 2013). While Lay and Skilling tirelessly worked to advance the energy trading business, Andrew Fastow, who later became the company’s Chief Finance Officer (CFO), would provide solutions on how to sponsor the strategy.

Instead of playing the gate-keeping roles, Andrew Fastow created a toxic corporate culture that led to a loss of over 40 billion US dollars (Di Miceli da Silveira, 2013). For example, he established a financing system that allowed Enron’s access to capital. He also ensured that financing was incredibly cheap. Debts were not reflected on the balance sheets. The firm looked healthier than what it was in reality. Hence, Enron misstated and/or misrepresented financial reports. Fastow chose to withhold crucial information on the company’s performance from scrutiny by shareholders. Hence, the misrepresentation of the corporation’s performance, which translated into increased stock prices, persuaded investors to pump more money in the form of equity into the firm with the hope of earning high returns.

Through witty efforts of non-disclosures put in place by Andrew Fastow, later disclosures revealed Enron’s four main areas of deceit (Di Miceli da Silveira, 2013). Special Purpose Entities (SPEs) became the tools and avenues for manipulating Enron’s earnings coupled with revenues. Hence, shareholders and any other enforcement body did not discover non-disclosure intents. The mark-to-model accounting strategy enabled Enron to book high profits at the point of contract initiations while ignoring the future performance of such pacts. Many of the company’s executives, including Andrew Fastow, were the architects of ensuring information asymmetries with the goal of serving their self-interest (Di Miceli da Silveira, 2013).

For example, a U.S. District Court found the company’s auditor, Arthur Andersen, guilty of destroying documents that would have helped SEC in its investigations. Hence, the scenario of Enron is beneficial since it points the need for financial disclosure and the corresponding consequences in case of misappropriations. Contemporary shareholders and even the companies’ staff members are benefiting from accountability and independence enhanced through auditing firms that encourage organizations to engage in full voluntary disclosures of their financial operations.

Under the U.S. Bankruptcy Code, Chapter 11, Enron applied for bankruptcy. However, no disclosure efforts were adopted to ensure that the firm benefited through the witnessed increased financial performance during future disclosures. However, according to Di Miceli da Silveira (2013), the case of Enron is a benchmark for other organizations that seek to find out how disclosures can benefit a firm as discussed in the literature review and other section of the paper.

Indeed, the case helps in understanding the wisdom behind the formulation and implementation of the 2002 Sarbanes-Oxley Act (Chen & Huang, 2013). Before the endorsement of the Act, various banks authorized loans to corporations, including Enron, without a clear understanding or else ignoring any risk involved. In the case of Enron, some investors falsely interpreted the willingness of banks to lend money as a key indicator of their financial health and integrity.

The experiences in the pre-Sarbanes-Oxley Act period prompted its ratification to ensure that investors made investment decisions that were backed by properly and accurately disclosed accounting information for any publicly traded company. Regulations such as Sarbanes-Oxley could have been important to preventing Fastow from making misinformed financial decisions.

Conclusion

Publicly traded businesses have the responsibility of disclosing their financial information. Although they may accomplish this requirement voluntarily, firms may suffer from the high cost of capital, low stock prices, and value in case insiders or agents, including managers, fail to fully divulge or disclose any misstated financial information. These two situations impair the ability of investors to make vital investment decisions since the information available to them is inaccurate or largely misleading.

Considering that laws and regulations mandate regulatory bodies such as SEC to investigate cases of non-disclosures or malpractices, for instance, earnings manipulations in financial reports, businesses that are found guilty experience poor public image, leading to the erosion of consumer loyalty. This situation negatively influences the companies’ financial performance. Therefore, apart from avoiding penalties and fines imposed on businesses that fail to divulge their financial performance information as directed by SEC, non-disclosure has long-term negative effects on firms’ financial standing. As evidenced by the case of Enron, the 2002 Sarbanes-Oxley Act discourages managers from engaging in accounting malpractices such as non-disclosures with the objective of siphoning investors’ money through fraud.

References

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