Introduction
After the sudden collapse of the energy giant Enron in January 2002, financial statements seem a lot less hard and objective than they once did. Enron caused widespread distress among equity shareholders, as a company with an equity market capitalisation of over $70 billion became worthless in just over a year (Burton 2002). Enron’s collapse was also a calamity to many of its employees, who not only lost their jobs, but saw the value of their 401k pension plans invested in Enron stock disappear. Inquiries into Enron’s collapse indicated that it resulted from major failures of corporate governance. Certain senior Enron executives appeared to have made significant profits from secret deals made with the company. The board of directors appeared to have failed to control such behavior, just as it rubber-stamped the production of accounts that failed to disclose material factors such as significant off-balance sheet debt. The Enron board also seemed to ignore reports from middle ranking executives exposing dubious practices. In February 2002 US Treasury Secretary Paul O’Neil announced planned changes in the law making it easier to punish corporate executives guilty of misleading shareholders:
Enron and Accounting Practices
Indeed, the Enron debacle focused attention on US accounting practices, and highlighted the relationship between companies and the accounting firms who as auditors were meant to confirm the accuracy of financial statements. Burton Malkiel, Professor of Economics at Princeton is a long-time observer of financial markets. For many years corporate governance experts had worried over potential conflicts of interest when accounting firms acted as both consultants and auditors to the same firm, but these conflicts burst out into the open after Enron. The auditors to Enron were Arthur Andersen, one of the top five firms who dominate the global accounting market (SEC Says Corporate 2002). The fallout from Enron’s collapse left Andersen facing legal challenges including a criminal charge from the US Department of Justice. About the same time, the SEC announced that it might seize the profits of company executives who made profits by selling company stock while earnings were inflated. It noted that Enron executives had sold $1 billion in company shares before the share price collapsed on news that charges would reduce earnings by $585 million, and revelations of off-balance-sheet debt The SEC also announced that it would assess the performance of the audit committee of any company whose financial reporting was investigated by the SEC (‘Socially Responsible Firm Publishes 2002). SEC director of enforcement Stephen Cutler explained:
An audit committee, or audit committee member cannot insulate herself or himself from liability by burying his or her head in the sand. It just won’t work that way. In every financial reporting matter we investigate, we will look at the audit committee
Reputation and DIS
The damage to its reputation also led to a number of its major clients such as Merck replacing it with alternative auditors. In March 2002 Domini Social Investments (DSI) issued new proxy voting guidelines that had been revised in the light of Enron (‘Socially Responsible Firm Publishes 2002). The new guidelines stated that DSI would vote against the appointment of auditors who were not clearly independent, while it would also vote against companies whose boards did not have a majority of non-executive directors. DSI tightened up its rules on executive remuneration, tying executive stock options to the overall performance of the company, not just the changes in its share price. The case of Enron shows that violation of accounting principles and issues can lead to bankruptcy and legal responsibility of the company’s executive team.
References
- Burton Malkiel, ‘(2002). The Lessons o Enron, Wall Street Journal, 2002.
- SEC Says Corporate Audit Panels under Scrutiny in Agency Probes, (2002). Bloomberg newswire.
- ‘Socially Responsible Firm Publishes 7th Annual Proxy Voting Guidelines Tightening Auditor Independence Requirements in Wake of Enron Collapse’, (2002). Bloomberg newswire.