Unethical Behavior in Accounting
The Enron scandal in 2001 had a significant impact in regulating the accounting practice. The scandal is considered by many as the worst example of unethical accounting behavior in the modern business environment. The scandal was not an isolated incident in the era of “loose” accounting principles: Worldcom, Halliburton, Rite-Aid, Adelphia Communications and Xerox were also found guilty of violating generally accepted accounting principles (GAAP) in preparing tax documents.
Global accounting firms such as Arthur Andersen, KPMG and Deloitte Touche were at best seen as grossly negligent and at worst co-conspirators in the scandals. A common theme among the scandals is the violation of accounting principles in reporting company revenue. Since the companies involved are evaluated by investors on the basis of reported revenue and company executives are largely compensated with company stock, many leading CEO figures were highly motivated to report accounting documentation that supported a healthy picture of their firm’s profitability.
The regulatory system was designed such that reporting and audit practices from independent accounting firms following GAAP principles would prevent this from ever happening, but that system failed repeatedly in the early years of the new millennium. The Enron scandal stands out among the era as having the most impact in creating the Sarbanes-Oxley legislation to prevent the practices from reoccurring. Founded in 1985, Enron sought to take advantage of the deregulation and privatization of energy utilities to offset risk in energy pricing swings of the company’s core product, natural gas pipelines (Canadian Broadcast Company [CBC], 2006).
By 2000, Enron was reporting revenues in excess of $100 billion, a 50% jump from prior year reporting (Canadian Broadcast Company [CBC], 2006). Even for an industry darling like Enron, named by Forbes as “One of America’s most Innovative Companies” for six consecutive years, questions began to arise regarding the validity of their earnings reporting. Following Ken Skilling’s unexpected resignation, Wall Street began to press Enron for more substantive information to back up their revenue claims.
What came to light was that Enron, in their financial disclosures, made heavy use of “what is called “mark-to-market”-actually “mark-to-estimate”-practices” (Haldeman, Jr. , 2006, 6). This was a practice of using the income approach to valuation using unobservable inputs. As a result of their accounting practices, the companies valuation varied so greatly from their actual performance, “it could be argued that Enron resembled an organized crime syndicate; efforts to mislead people required the co-coordinated efforts of many people”.
Basically, the mark-to-market approach allowed Enron to estimate their profitability in any given financial period though counting “the entire future worth of a business deal as revenue in the year the deal was signed” (Carney, 2006, 9). The potential for abuse in using this form of revenue reporting, by example a 30 year energy contract could be counted as revenue of 30 years worth of revenue estimates in year one (Carney), created the massive “reality gap” in Enron’s financial reporting as this lever was consistently abused by the network of Enron conspirators.
This practice, counting lifetime estimated future revenue potential as current revenue, or the “Enron” accounting method, or “Back to the Future” accounting in reference to the practice of capturing future gains in the present, was the fundamental flawed practice at the center of the scandal and has come under scrutiny even recently as its practice was widespread.
Accounting firm Arthur Andersen was buried by the court of public opinion and paid a heavy price for their involvement in the scandal, “In holding the accountants accountable, the jury in essence sanctioned the entire bean-counting industry for its failure to police rogue corporations” (Thomas, 2002, 2). It was revealed that, under pressure of scrutiny from the Securties Exchange Commission, the firm acted deliberately in the practice of “sanitizing the record so the SEC would have less information” (Thomas, 3).
In the Enron example, both the firm and their accounting vendor were guilty of unethical behavior not just in financial reporting, but in reaction to the specter of investigation from the SEC. This case ultimately led to the creation of the Sarbanes-Oxley act which created a separation between financial preparing and auditing and implied greater responsibility on the shoulders of company chief executives in the legitimacy and accuracy of their financial reporting.
References
- (2002, January 17). Enron Timeline. Houston Chronicle. Retrieved from http://www. chron. com/disp/story. mpl/special/enron/1127125.html Canadian Broadcast Company (2006).
- The Rise and Fall of Enron: A Brief History. Retrieved December 26, 2008, from http://www. cbc. ca/money/story/2006/05/25/enron-bkgd. html Carney, T. (2006).
- Feds were Accomplices to Enron Crooks. Retrieved December 26, 2008, from http://cei. org/gencon/019,05371. cfm Haldeman, R. G. , Jr. (2006).
- Fact, Fiction, and Fair Value Accounting at Enron. The CPA Journal. Retrieved from http://www. nysscpa. org/cpajournal/2006/1106/infocus/p14. htm
- Thomas, C. B. (2002). Called to Account. Time. Retrieved from http://www. time. com/time/business/article/0,8599,263006,00. html
