Enron

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The Quality of Financial Information

Published December 19, 2013 by Mayrbear's Lair

financial-reporting

The holidays are creeping up on us and I just realized, I neglected to post Wednesday’s blog. This post is significant to my research work in financial analysis because it helps us understand that in order to keep apprised of how well a company is doing, the quality of financial reporting is the key component that determines whether the statements paint an accurate portrait of the firm or not. For example, because of scandals that occurred from companies like ENRON, AEI, and WorldCom, a revolution occurred with respect to financial reporting. According to Bahnson and Miller (2002) old practices and habitual thought processes with respect to accounting principles were put aside and replaced with new strategies and systems. As a result, accountants and finance executives are expected to embark on a different path that embraces a new shift in the bookkeeping paradigm called quality financial reporting (QFR). For financial managers to consider investing in a company they are looking for accurate information about two significant components: (1) opportunities to receive future cash flows, and (2) information about those opportunities (Bahnson & Miller, 2002). QFR provides complete information to investors and creditors to give them confidence in a company’s performance abilities. Much of the information provided on financial statements can be intimidating to many managers and entrepreneurs. This is a typical response from those who lack the financial intelligence required that can help them make more effective decisions in running their firms. Berman and Knight (2008) explain that the figures on financial statements help strategists determine a variety of estimates and assumptions. Learning how to assess that information helps planners to identify the bias of the data provided, in one direction or another (Berman & Knight, 2008). In this context, where financial results are considered, bias merely suggests that the numbers may be skewed in a certain direction. In other words, bookkeepers and finance professionals are trained to use certain assumptions and estimates rather than others who view the reports for other purposes. QFR is essential because it provides sufficient information to identify not only the source of those gains, but whether there are any other events or circumstances that could have an effect out the outcome, like pending litigation.

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Much of the information provided on financial statements can be intimidating to many managers and entrepreneurs. This is a typical response from those who lack the financial intelligence required that can help them make more effective decisions in running their firms. QFR is effective at painting an accurate view of the company’s financial condition. For example, revenue should not be recognized until there is evidence that a sale has transpired. In other words, the recipient has received delivery of the product or completion of the services rendered and revenue is collected. Many companies, however, violate this policy and report revenue prematurely without all criteria being met. Analysts can look for clues of false revenue reporting in the financial reports. For instance, the notes can reveal the company’s position with respect to collecting revenue policies to ascertain whether any changes occurred and determine the reason for the changes as well as the impact they can have.  Another clue is an analysis of the financial statements to determine the pattern of movement from sales, inventory, and accounts payable. For example, spikes in revenue during the final quarter may be a sign of revenue reported prematurely unless there is a specified reason for the spike to generate sales (like an end of the year close-out sale to liquidate inventory). Companies do not commonly experience spikes from sales in the fourth-quarter so this immediately raises flags. Other methods companies use to raise revenue levels include keeping the account records open longer at the end of the allotted accounting period. Some corporations on the other hand, use deceptive tactics like reporting gross sales rather than net to show higher revenue. For example, a company that is acting as an agent for another organization may collect their revenue in the form of a commission. According to regulations set forth by the GAAP (generally accepted accounting practices), agents are not considered the owner of merchandise being moved. Fraser and Ormiston (2010) explain that the GAAP requires the reporting of Gross Revenue for Principal Owners and Net Revenue for those who act as a representative in the in the sale of a product or service.  In other words, because agents are not considered the owners or originators of the product who assume the risk of the merchandise, the company acting as the agency can use the net method for recording revenue. Therefore knowing that a company collects revenue as an agency analysts can scrutinize the data closely to determine whether they reported gross or net revenue.

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QFR is also important because it can help strategists understand the various inventory valuation methods. For instance, there are times when companies produce lower or higher earnings due to the fluctuation of inflation. Analysts again must look to the financial notes to determine the details of the company’s accounting policies to disclose whether the changes in revenue occurred due to LIFO (last in first out) or FIFO (first in first out) inventory cost flow accounting assumptions. If the value of the products sold, for example, falls under its original cost, the product is written down to reflect the market value and is determined by the cost to replace or produce an equivalent. This means that write downs can also play a part in the company’s profit margins which affects the comparability and quality of financial reporting. Accounting practices that do not provide details and incorporate misleading information is considered an unacceptable practice and any CEO that signs off on documentation that provides a misrepresentation of the truth is putting their career at risk and may face dire consequences as a result. That should be incentive enough to engage in QFR. To surmise, QFR provides investors the ratios that reveal whether companies are able to buy inventory and pay their bills. Furthermore, they provide profitability ratios that help creditors understand how much capital the company is generating while efficiency ratios reveal how well the company is managing their assets. The more complete these reports are the more likely they are to reduce shareholder uncertainty. In the eyes of investors and creditors, certainty reduces risk and reduced risk, provides shareholders with the satisfaction of a lower rate of return. In the long run, a lower rate of return means a lower cost for capital, which ultimately produces a higher stock price for the company. In conclusion, providing quality financial information is an essential component to management that contributes to a company’s long term success.  Tomorrow’s blog will post on schedule and will take a look at how different conflicts of interest can effect quality reporting.

References:

Bahnson, P., & Miller, P. (2002). Quality financial reporting. New York, NY: McGraw-Hill.

Berman, K., & Knight, J. (2008). Financial intelligence for entrepreneurs. Boston, MA: Harvard Business School Press.

Fraser, L., & Ormiston, A. (2010). Understanding financial statements. Pearson Education.

Ethics and Federal Compliance Laws

Published July 24, 2013 by Mayrbear's Lair

Aristotle

To comprehend the topic of business ethics, it is important to identify the voluntary and legally required aspects of institutional practices and the behavior that supports it. Aristotle (384– 322 BC) believed that a person’s good or bad character was developed by habituation. In other words a person’s goodness or wickedness is developed as the result of repeatedly engaging in acts that have a common quality. These repetitious acts rely on an individual’s natural aptitudes and tendencies to gravitate towards righteous or immoral behavior (Aristotle, 2012).  In other words, the formation of a person’s character emerges by actions that are committed repeatedly in a certain manner and as a result of being guided or receiving direction externally to support these patterns. Once the behavior is understood by the individual, they can then choose to engage their free will. The continuation then, of the behavior, becomes a habit which over time translates into second nature. This demonstrates how a leader’s conduct and business practices cultivate a climate that is adopted by subordinates. During the Enron scandal for example, investigators discovered that Enron’s leaders developed a culture of deceit that was supported by their top executives, board members, and corporate attorneys, to gain the competitive edge and ensure capital gains.

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The Enron collapse revealed deep failings that existed in the American accounting system and in the operation of corporate boards. Enron and other widespread corporate accounting scandals resulted in Congress establishing the Sarbanes-Oxley Act (SOX). It was designed to create a federal oversight system to monitor corporate accounting practices by making financial fraud reporting a criminal offense. Boatright (2009) reported that the SOX Act also increased the penalties for executives that engage in criminal activity. In addition, SOX addressed a wide range of provisions to require corporate transparency in three major areas: financial reporting, corporate boardrooms, and criminal law (Boatright, 2009). Poor business decisions alone however, did not result in Enron’s downfall. What was cleverly disguised from stakeholders was insider plundering. Because of this, Congress feels that Federal oversight is needed. Investors rely heavily on financial reports and in turn these reports can become the vehicles that lead to fraud. For example, by presenting a false image, executives can cover poor performance outcomes to maintain their lavish lifestyles. SOX changed the way corporations address problems with accounting and auditing. It requires that every publicly traded organization establish an independent auditing committee that is solely responsible for detecting fraud. It also supports internal whistle blowing by mandating all companies incorporate policies to support employees reporting acts of fraud without fear of retaliation.

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CEOs careers are now on the line. They are required to sign off on company financial forms to ensure their processors have complied with all mandates. Many corporate chiefs complain about the amount of time and money that is invested to comply with SOX regulations, but most agree that it is worth the trouble to reassure investors. Ferrell et al. (2012) posit that in addition, the law requires corporations to design a code of conduct that includes transparency and accountability in financial reporting to stakeholders (Ferrell, Fraedrich, & Ferrell, 2013). Experts expect further misconduct to occur despite the regulatory laws because global competitors are not required to comply with these regulations. This means that more scrutiny is called for because the more integrated world markets become, the more difficult it is to compete on a global level when the playing field is uneven. In the meantime, only time will reveal the long term results.

References:

Aristotle. (2012). Ethics. Seattle, WA: Amazon Digital Services, Inc.

Boatright, J. (2009). Ethics and the Conduct of Business (Sixth ed.). Upper Saddle River, NJ: Pearson Education, Inc.

Ferrell, Fraedrich, & Ferrell. (2013). Business ethics and social responsibility (9th ed.). Mason, OH: Cengage Learning.

Regulatory Measures

Published July 12, 2013 by Mayrbear's Lair

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It seems like practically every day a new scandal is spotlighted in the media regarding ethical misconduct. For example, recently celebrity chef Paula Deen quickly lost several corporate endorsement deals because of revelations that she engaged in behavior that reflected views of bigotry and discrimination. Other scandals, like Enron on the other hand, were just as shocking because what appeared as a highly ethical organization was, in fact, quite the opposite. It is not clear whether Deen will survive her scandal, but because of Enron, regulatory measures were implemented to prevent another occurrence of this nature. Ferrell et al. (1998) suggested that because of events like Enron, the federal government intervened to help guide the ethical conduct of organizations and institutionalized ethics as a preventative measure to prevent corporate legal violations (Ferrell, LeClair, & Ferrell, 1998). This research is focused on three significant regulatory measures: (a) The Federal Sentencing Guidelines for Organizations (FSGO), (b) The Sarbanes-Oxley Act of 2002, and (c) the Consumer Financial Protection Bureau (CFPB). This study identifies the events that led to the development of these measures and scrutinizes the impact these directives played on business ethics. In addition, case examples are included to highlight how these mandates affect ethics in business. The results of these findings conclude that in a business arena, leaders who navigate without regulations are conducive to ethical misconduct.

Three Significant Regulatory Measures

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The Federal Sentencing Guidelines for Organizations (FSGO)

When regulatory measures are implemented, they have a great impact on the ethical manner in which organizations behave and operate. Ethical compliance programs are more of a process and a commitment from organizations to practice ethical behavior than they are specific blueprints for the direction of ethical conduct. In this context, regulatory measures serve to help leaders achieve positive outcomes with social awareness and accountability. Ferrell et al. (1998) pointed out that today’s leaders are dealing with complex issues that require effective leadership skills. For example, managers are required to identify, comprehend, and implement the acceptable use of corporate funds; recognize the falsification of important documents and account records and pinpoint controversial techniques sales representatives use for closing deals. These are some of the common challenges managers face in the modern workplace. In addition, competition, political pressure, and different value systems also influence ethical conduct (Ferrell, LeClair, & Ferrell, 1998). Organizational ethics programs are established, therefore, to outline the parameters of accountability and responsibility with respect to acceptable business conduct. For instance, news reports revealed unethical practices in the grocery industry where, in some cases, managers will re-date food products to extend a product’s shelf life. This kind of ethical misconduct is identified as a white collar crime (WCC) and as a result, the government responded by issuing the Federal Sentencing Guidelines (FSG).

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The goal of these mandates was to reward organizations for implementing legal and ethical compliance programs. They were created to encourage corporations to monitor internal control systems by decreeing punishment and restitution should the systems fail. For example, to demonstrate compliance, a company is required to create and document an internal conformity program by demonstrating their ethical culture. In addition, the legal standards are communicated throughout the entire organization to make sure violations do not occur. If and when they do occur, management must provide evidence that a proactive compliance program was implemented. In short, the main objectives of the FSGO are to take aggressive actions to police and self-monitor an organization’s ethical behavior to avoid unethical acts and punish perpetrators that are engaged in WCC and misconduct. The penalties for violating these mandates include the remedy of any harmed caused, are subject to stiff fines, and include any further actions required to reduce future criminal misconduct.

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The Sarbanes – Oxley Act of 2002 (SOX)

When corporations display unethical conduct that affects the public on a grand scale, the government is forced to step in to enforce penalties that will influence social responsibility. For example, the Enron financial disaster was one of the most significant events that occurred to rattle the modern business world. It revealed a level of corruption in the business arena on an unprecedented scale. For example, to many individuals, business ethics are considered different than individual ethics. Because of this perception, Enron staffers that were cognizant of the firm’s off-balance partnerships accepted these practices as part of doing business in a competitive market. Because they were informed these partnerships were legal, employees did not perceive this conduct as an issue of ethics. Bredeson & Prentice (2010) explained that in order to avoid this happening again, the Sarbanes-Oxley Act (SOX) was developed and imposed the most important security mandates since the great stock market crash of 1929, which led Congress to pass the original federal securities laws. SOX consists of provisions that: (a) created a new federal agency, (b) restructured the entire accounting industry, (c) implemented Wall Street practice reforms, (c) created extreme alterations in corporate governance practices nationally and internationally, and (d) attacked insider trading and obstruction of justice (Bredeson & Prentice, 2010). Since then, to support these laws, the Public Company Accounting and Oversight Board (PCAOB) was developed and, together with the SEC, issued additional rules and policies to implement SOX’s many regulations.

In addition to enforcing corporate giants to revamp their governance practices, the PCAOB was also designed to protect whistleblowers. Boatright (2009) suggested that protection to private sector employees who acted as whistleblowers was a significant issue that SOX addressed for the first time. In other words, as a result of the massive fraud events from Enron, WorldComm, and other conglomerates, this reform prevents the retaliation from corporate institutions against any employees that provide law enforcement evidence which relates to the exposure of trade commission offenses (Boatright, 2009). However, the immediate purpose for SOX was to restore stakeholder confidence in the securities market once again. Experts contend the only significant complaint leaders have about SOX is that post-Enron, SEC accounting rules require market to market estimations. This practice forces financial institutions to revalue assets in situations where the value is not easily ascertainable due to pricing fluctuations. All in all, most leaders agree that despite the additional costs and extra energy required to ensure big corporations adhere to these provisions, SOX effectively enforces best practice policies in both the corporate and accounting worlds.

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The Consumer Financial Protection Bureau (CFPB)

The mortgage and loan crisis of 2008, where lenders failed to educate brokers about the disastrous consequences of falsifying financial data to help people secure loans, contributed to organizational misconduct in the financial services industry. As a result, the government stepped in once again to take more regulatory measures by outlining the legal framework to help guide ethical practices in the financial service industry. Carpenter (2012) contended that as a result of that crisis, Congress was forced to pass significant reforms through a new regulatory system called the Dodd-Frank Wall Street Reform and Consumer Protection Act. This act entitled stakeholders financial protection and established the Financial Protection Act of 2010 (CFP Act). The CFP Act in turn served to help establish the Consumer Financial Protection Bureau (CFPB or Bureau) within the Federal Reserve System  (Carpenter, 2012). The Bureau was designed to oversee and provide the rulemaking, enforcement, and supervisory powers over a wide range of consumer financial products and services as well as the institutions that sell them.

The laws also enable the Bureau principal rulemaking authority over many federal consumer protection laws that were enacted prior to the Dodd-Frank Act. Among the numerous consumer protection laws developed were the Truth in Lending Act and the Real Estate Settlement Procedures Act. These directives were designed to help stakeholders comprehend the complicated lending transactions they engage in with more transparency and accountability. In short, the Bureau serves as a system for bank supervision to ensure corporations are in compliance with federal consumer financial protection laws and make sure the markets work for families rather than bankrupt them. In 2011, the Bureau reported their operations included the assessment of each institution’s internal ability to detect, prevent, and remedy violations that may harm consumers by examining the corporation’s internal procedures (CFPB Public Affairs, 2011). These mandates and regulatory measures serve to insure that corporate moguls follow ethical governance practices to avoid further financial disasters from occurring in financial service industries.

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Conclusion

The law is ubiquitous. It enables, prohibits, and regulates practically every activity of a human being directly or indirectly in some way. Mann & Roberts (2013) purported that in an effort to resolve moral issues, experts have struggled for years to fine tune various ethical behavioral systems. Laws were created to help define relations between individuals and corporations. These relations have an effect on the economic and social order and are the products of civilization’s governance practices. In this respect, the law is designed to reflect the social, political, economic, religious, and moral principles of a society (Mann & Roberts, 2013). In other words, laws are used as tools for social control. Their function is to regulate and guide conduct in human relations.

When corporate leaders misuse their power, government agencies step in to create mandates that outline acceptable and ethical conduct which protects people and keeps the public safe. Ferrell et al. (2013) contended that these regulatory measures provide motivation for organizations to develop core practices throughout their organizations to ensure ethical and legal compliance and are designed to move emphasis away from an individual’s moral obligations. Instead, focus is put on the development of structurally sound organizational core practices and structural integrity for both financial performance and nonfinancial performance purposes. These methodologies include access to communications, compensation, social responsibility, corporate culture, leadership, risk, stakeholder perceptions, and the more subjective aspects of earnings, corporate governance, technology, and other significant areas (Ferrell, Fraedrich, & Ferrell, 2013). The findings of this research deduce that regulatory measures implemented by the federal government have played a significant role in the development of ethical behavior in organizations because time and time again, history proves that many influential leaders who are motivated to achieve high levels of success, and operate without regulations, are unable to avoid the temptation to engage in ethical misconduct when the stakes, profits – especially when competition in the marketplace is extraordinarily high.

References

Boatright, J. (2009). Ethics and the Conduct of Business (Sixth ed.). Upper Saddle River, NJ: Pearson Education, Inc.

Bredeson, D., & Prentice, R. (2010). Student guide to the Sarbanes-Oxley Act. Mason, OH, USA: Cengage Learning.

Carpenter, D. (2012). The consumer financial protection bureau. Washington, DC, USA: CreateSpace Independent Publishing Platform.

CFPB Public Affairs. (2011, July 12). Consumer financial protection bureau outlines bank supervision approach. Treasury Department Documents and Publications. Latham, US: Federal Information and News Dispatch, Inc. Retrieved June 26, 2013, from http://search.proquest.com/docview/876103177?accountid=32521

Ferrell, Fraedrich, & Ferrell. (2013). Business ethics and social responsibility (9th ed.). Mason, OH: Cengage Learning.

Ferrell, O., LeClair, D., & Ferrell, L. (1998, March). The federal sentencing guidelines for organizations: A framework for ethical compliance. Journal of Business Ethics. Dordrecht, Netherlands: Springer Science & Business Media. Retrieved June 26, 2013, from http://search.proquest.com/docview/198195145?accountid=32521

Mann, R., & Roberts, B. (2013). Business law and the regulatoin of business. Mason, OH, USA: Cengage.

A Look at the Ethics and Organizational Culture of ENRON

Published June 10, 2013 by Mayrbear's Lair

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Due to a number of highly publicized scandals including AIG, Countrywide Financial, Fannie Mae, and Enron, the ability to identify and manage complex business ethics issues has become an important priority. According to Shaw (2008) Enron was the organization that stood out among others because they were showing enormous rates of profit. As a result they quickly became favored by Wall Street and subsequently grew to become the seventh largest company in the US, was highly respected, and was quickly placed on a financial pedestal. Enron was looked at as innovative, forceful and most important, highly profitable. However, the truth was that while CEO Kenneth Lay was recommending stock to his employees, he and other executives were secretly cashing in their own shares and jumping ship. According to Shaw, Enron’s market value was $28 billion just two months prior to their filing bankruptcy. This is the reason shareholders and investors were completely caught by surprise. Unfortunately, the corruption of Enron execs affected more than $1 billion in the retirement accounts of their employees (Shaw, 2008). The leaders created a culture based on personal gain and profit, with a complex and complicated accounting system. In addition, employees were meshing into the corrupted culture because they too were receiving high levels of rewards. The organization established an atmosphere based on financial prowess and illusion. Workers and shareholders were unable and too comfortable with their fortunes to make ethical choices and stand up against the majority who ruled. This is one way corruption thrives. In fact, there are some organizational leaders that initiate new members into their elite boys clubs by taking them out to brothels encouraging them to engage in elicit behavior. This is a well known tactic corrupt leaders used to blackmail employees, should they later have inclinations to become whistler blowers.

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A poor reputation can damage an organization’s image and destroy the public’s trust. Ferrel and Fraedrich (2012) contend that employer decisions affect more than just those of their employees. In fact, their decisions most likely have impact on shareholders, customers, suppliers, and society as well (Ferrell & Fraedrich, 2012). Making good ethical decisions should be consistent throughout an organization on every level. Evidence revealed that Enron executives, through their operations, informally communicated and designed a culture whose objective was to achieve personal gain and organizational success at whatever cost, regardless of regulations and policies. Additionally, the climate consisted of executives who resorted to public use of vulgarity that created an atmosphere to encourage more of the same behavior from staff members. One reason for this is that some employees look up to their superiors and strive to become like them. Others just want to fit in and partake of the spoils. As a result, they tend to model and absorb similar methods as a justifiable means to an end. Because of Enron’s high level of success, a complicated accounting system to create misdirection in their underhanded practices, and a legal team to support those goals, Enron execs believed their organization was too big to fail.

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To prevent this from happening, Enron execs should have created a culture that was ethical and responsible from the onset. Instead, they established an organization of people that operated in a corrupted fashion and disguised their unethical behavior under the guise of a very ethical public persona. In addition, Enron’s CEO should have enlisted an auditing firm that had a track record for ethical practices. Shaw’s (2008) research disclosed that Enron’s auditing firm (spearheaded by Arthur Andersen), failed to make Enron’s public records reflect their purported financial reality. Instead, they were focused on their auditing and consulting fees and neglected their fiduciary responsibilities. Also, Enron’s CEO should have made sure all documents were turned in to authorities. Instead, one of the partners at the auditing firm was caught shredding incriminating records. Furthermore, Enron’s downfall exposed conflicting interests in Wall Street Analysts who were highly compensated for supporting their investment banking deals. Enron’s CEO should have enlisted Wall Street connections that were engaged in ethical practices. Finally, large banks like Citibank who did business with Enron, also participated in corrupt business operations in their manufacturing fraudulent financial statements (Shaw, 2008). Enron’s leaders should have identified banks that  operated ethically. In short, Enron was a well-oiled machine of corruption, reminiscent of organizations run by the Don Corleone family from Mario Puzo’s famous books. Enron had many influential people and corporations “in their pocket” that were also corrupt. This was the strategy they employed to engage in their unethical practices. Officials and staff members looked the other way because of the massive amounts of profits they were receiving. In conclusion, the Enron story is a classic example of how absolute power tends to breed absolute corruption.

References:

Ferrell, O., & Fraedrich, J. (2012). Business ethics: Ethical decision making (9th ed.). Mason, OH: South-Western College Publishing.

Shaw, W. (2008). Business ethics. Belmont, CA: Thomas Higher Education.