Reaction Paper: The Downfall of Enron
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Although several aspects attributed to the downfall of the energy giant Enron, the collapse is primarily attributed to the firm’s questionable accounting principles and complex financial arrangements. Dibra (2016) argues that the company has a well-known track record in complex financial arrangements to help the company report unrealized profits and expand operations. For example, the company used complex financial transactions by partnering with Raptor to hedge its profits and losses for its investment in internet and water broadband. When the company failed to realize profits in one venture, it would start a new partnership to finance other ventures and use the new venture to manipulate its financial outcomes. These complex financial arrangements were confusing and raised questionable accounting principles, although they were legal.
Thomas (2002) claims that the company’s top leadership led by the firm’s chief financial officer Andrew Fastow violated ethical laws by misleading its board of directors and audit committee on the high-risk accounting practice. Besides, Festow pressurized the company’s CEO Arthur Anderson to ignore the critical issues at hand. Fastow aimed to pressure the Executives in discovering new ways of hiding debts. He advocated for market accounting practice, an accounting practice based on the market value, which was inflated. Together with the other executives, Festow created unethical sophisticated financial practices, which made the companies deal bewildering, and only a few individuals could understand them. As a result, the majority of the executives were indicted for various charges, and some sentenced to prison. For example, Enron’s editor was convicted in the United States district court, although the ruling was overturned by the Supreme Court (Dibra, 2016).
Enron used investment banking in a special purpose entity in financing or managing risks related to specific assets. The special purpose entities were generated by the company and were used to transfer part of their assets and could apply for bank loans with low-interest rates or conduct other forms of financing since these special purpose entities do not have debts but only assets, thus less risky. Interestingly, it did not disclose or give any minimal information on the use of special purpose entities (Dibra, 2016). Although Enron created these companies, they had independent investors, most of whom were Enron’s executives and were mainly financed by debt. Enron used these companies to mitigate accounting agreements specifically by making up their debts. Consequently, to these deceptive measures, the company’s balance sheet always gave favorable results by decreasing its liabilities and exaggerating its profits and assets, which led to the collapse of the energy giant.
Lastly, the Federal Reserve Bank also played a role in Enron’s downfall as the system had a lot to do with the internet bubble. The few attempts by its president, Allen Greenspan, in deflating the bubble through words and criticizing the market for being an irrational exuberance did not come with actions. Instead, the Federal Reserve Bank allowed an expensive financial policy for years while permitting excessive liquidity to split the shares market speculations. According to Connell (2017), the bank should have intervened to cushion the bubble long before 2000 for it to work correctly and appropriately. Instead, the bank opted not to intervene and protect the small investors from the bubble and its consequences until the recession was booming.
References
Connell, M. (2017). The Fall of Enron and the Creation of the Sarbanes-Oxley Act of 2002.
Dibra, R. (2016). Corporate governance failure: The case of Enron and Parmalat. European Scientific Journal, 12(16).
Thomas, C. W. (2002). The rise and fall of Enron. JOURNAL OF ACCOUNTANCY-NEW YORK-, 193(4), 41-52.