ACC3116 FINANCIAL ACCOUNTING THEORY
Executive Summary
The purpose of the report is to derive learning from the experience of Enron from the research and analysis of relevant literature that contributed to its demise. The key theories that were considered are the efficient market hypothesis, information asymmetry and positive accounting theory. It is found that voluntary disclosure of pertinent information to stakeholders and the public can provide the optimal shield for contemporary firms to prevent the fate of Enron.
Table of Contents
Table of Contents………………………………………………………………………2
1. Introduction…………………………………………………………………………..3
2. Efficient Market Hypothesis……………………………………………..……….. .3
3. Implications of EMH Failure to Capital Market Research……………………….6
4. Asymmetrical Information…………………………………………………………..8
5. Option Grants………………………………………………………………………10
6. Conclusion………………………………………………………………………….13
List of References…………………………………………………………………….14
Introduction
Enron is already a history but contemporary firms can learn substantially from the mistakes its executives had committed which ultimately led to a sudden demise from the short-lived fame of its ground-breaking share performance. This paper discusses several topics that directly and indirectly relates theories, studies and evidences to Enron’s collapse. First, efficient market significance will be implied by discussing the reasons and effects of the failure to impound corporate factors to its share price. This will guide the learning towards capital market research. Second, the nature and role of information asymmetry to Enron’s demise will be explained. Third, strategic actions of corporate executives will be evaluated using the positive accounting theory. Lastly, conclusion is attached to highlight the learning and other relevant findings.
EMH
In a general analysis, there are some factors that should have affected the publicly-held share of a firm but are disregarded by its market price because market value are not exhaustive basis of firm performance. According to 2006), this is tackled in US cases way back in the advent of Great depression in 1934 (see Chicago Corp. v. Munds) to contemporary valuation parameter disputes (see Weinberger v. UOP Inc.) (). In the case of Enron, its complex financial structure is impounded in the share price because certain banks colluded in meeting the financial targets of the firm (2006). These banks intensify the complexity of how Enron’s reports are prepared that tagged the former as “problem solvers”. In effect, the efficient market hypothesis (EMH) semi-strong form () did not hold due to the fact that financial intermediaries that should have evaluated and restricted Enron in its doings are tolerated and even supported. Thus, new information that should have change the decision of the market as well as the share price did not take place.
Secondly, off-balance sheet (OBS) entities formed its part to distort share price as Enron misuse the good side of such legal provision which primarily aims to aid corporations to finance ventures (2002). As a result, EHM strong-form did not emerged in share price adjustment due to insider agreements within the firm (). If only Enron did not overuse the socio-economic spirit of OBS, the market may not erred in interpreting the corporation’s financial reports. In fact, OBS gave Enron high rating evaluation from rating agencies ( 2002). OBS entities are bounded for special purpose like access to capital and hedge risk available for Enron transforming its return on assets (ROA) and leverage looks excessively profitable and “on-boom”. The company abused OBS opportunity that ultimately led to its removal and the introduction of more stringent GAAP codes and other related laws (2002).
Perhaps, one of the biggest obstacles for EMH application (2003 ), the lack of disclosure of its financial and corporate reports helped Enron to skip from the market’s conservative analysis. This is because Enron failed to explain to shareholders among others factors that may affect their stake in the company like the complex financial structure or excessive OBS entities. These are methods and communications which do not have numerical/ financial equivalents that can suit to financial reports. Nevertheless, the firm’s Annual Report should have reflected them but (2002) commented in its 2000 Annual Report that the content had “spectacle presentation of characters and dialogs”. In effect, users of such reports (ultimately, consists the market for the firm’s shares) had unknowingly disrupted semi-strong and strong EMH. However, the weak-form have been excluded as excess returns earned based on financial data have no bearing ().
The independent audit that should have been provided by the facility between Andersen and Enron also prevented EMH especially the weak-form as the inclusion of fundamental analysis can create excesses returns (). The inability of the market to picture how auditors evaluated and authenticated Enron reports took them away from such analysis. This situation would not greatly distort share price, however, collusion existed between the client and the auditor that led to third party certification that was limited to compromised agreements of both parties ( 2003). As a result, even the semi-strong and strong EMH were adversely affected. Obviously, the public including the shareholders did not have audit dependence hints and information that would have impeded price escalation of Enron’s stocks due to positive (although, misguided) future outlook. One such evidence that proved the vitality of client-auditor independence was the declaration of Sarbanes-Oxley Act of 2002 (2005). According to (2001), the restriction will offer investors with financial information from a publicly-listed firm that has reliability and integrity.
Implications of EMH Failure to Capital Market Research
The historic Great Depression and Enron collapse are two cases in two different times that proved that EMH failure will not be discovered and addressed until adverse effects to stakeholders are at peak. This calls for a pro-active approach in conducting capital market research in which the endeavor should be infused even if obvious effects are yet to emerge. The more stringent policies may defer and discourage Enron-like firms temporarily but pro-activity to determine the culprit (client alone) or culprits (client plus auditor) is conceded to have its strategic merits for capital suppliers. Every potential and existing shareholders and creditors are now bound to get all the help they need from financial advisors, government and peers to secure their funds to entities that have at least a sprinkle of EMH or some degree of the weak-form. Otherwise, their investment can be easily diluted by the market and/ or the entity without even imploring some contingent measures. In simple terms, they will lose the battle without pulling out their swords and shields.
Being in chorus to the behavior of a certain financial market proved to be beneficial and less complicated for shareholders. The case of Great Depression and Enron is not an everyday case while the general pulse of market participants is oftentimes correct and profitable. However, there are several factors to consider when shareholders will completely give their trust and relate investment options to the capital markets. For example, the efficiency of stock exchanges in which corporate shares is traded out of their traditional operations. In economics, the role of the stock market is merely to provide a venue in which demanders and suppliers of capital can meet (1965). Today, this venue becomes complicated due to brokers and traders, regulation from the government and involvement of foreign firms and investors as well as complexity and uncertainty of the environment.
For example, the London Stock Exchange had abolished Big Bang scheme that led to de-motivated independent brokers and conversely allowing entities to have their own dealers (1999). In effect, the exchange can fail to limit the marketing campaigns private brokers can use to attract investors. As Enron primarily utilized the lack of corporate disclosure and insider trading to obtain its objective, this situation can mimic the manipulative feature by misleading promises and bias advises. In addition, the abolishment can hinder broker efforts (both private and independent) to seek markets diligently due to their “focused” clients that can ultimately limit the flow of capital in the economy. Limiting the access to capital and interested borrower stimulates as well aggravates the inclination of firms to implement actions that continuously mitigate the functions and invisible hand of EMH. Another Enron or perhaps Great Depression can follow in the coming years.
Asymmetrical Information
According to , asymmetrical information is a condition when one party in a transaction has a more substantial and relevant information than the other party. In this case, it is likely that the former party will have higher bargaining power throughout the transaction until the latter discovers the error or default in the agreement. When applied in the corporate setting, the theory of the separation of ownership and management can illustrate this case. The theory states that investors have an indirect access to inside information with regards to the real corporate value compared to directly managing executives (2002). As observed, investors can be applied with management tactics to raise self-vested interests of executives. Traditionally, the latter opt to sell and issue shares when the firm is overvalued as well as the investors are unaware of such condition. However, this dogma had long been discovered by the market. as such, investors repel this executive behavior by revaluing their shares causing a negative market reaction. In the end, the management could not maximize the traditional tactic due to unfolded information of its significance to investors.
The supposedly first stage of the collapse of Enron was derived from Skilling drastic imposition of rigid and hostile retention scheme (2002). This is a condition of moral hazard (1999). Before took the post of Division Manager, former employees have symmetric information with the firm regarding their worth. However, when tackled human resource issues, he tried to abort loyal but change-averse staffs with master-level and doctorate degree holders without full disclosure of the plan so that former staffs have adjusted their work ethics accordingly. In a different case, the unethical accounting practice of Fastow and his collusion with auditors is an information asymmetry under signaling (2002;1999). The victims are the shareholders unknowingly handed by non-transparent corporate and financial reports. and signaled to each other about the hidden action which transformed shareholders as one having asymmetric data from the start of the contract.
Information asymmetry to employees was regarded as the first dark stages of Enron collapse because staff resistance to change is one of the top causes of failure of major corporate changes (2002). Skilling, who had substantial experience as financial advisor, undermined human resources when it insisted to be hostile on them. Without loyal employees, quality management is adversely affected because highly-qualified but new employees are neither capable nor motivated in conforming to the new methods under Skilling culture. This scenario may have been integrative-planned by and to limit the size of familiar employees to minimize their unethical exposure. At this point, Enron was not looking strategically rather financially. The incomplete information staffs would have been received (like the transition to highly-qualified and scholarly recruits) sparkled the negative atmosphere throughout the organization. It ultimately impeded cultural cohesion and deepened the opportunity of higher executives to execute their self-vested practices.
On the other hand, information asymmetry to investors as well as rating agencies led to unguided substantial investments. This formed the foundation for the fame and fortune of Enron to emerge. Although signaling is primarily evident to investors that purchase stocks or those who increase their holdings under Andersen regime, moral hazard can be more appropriately tagged to initial investors of the company way back in 1980s. The loophole of this practice by colluding parties, however, is that the huge amount of stakes that used to support the firm’s operations, stock attractiveness and continuity of the unethical practices made them very crucial to the existence of Enron. As a result, when the scandal cropped up in the offing of the new millennium, the firm had faced not a gradual demise rather instant shutdown.
Option Grants
Under opportunistic perspective, the economic incentives of Enron can vary depending if they opt to engage in fraud or take risks with regards issuing options. The perspective is an accounting policy used by an organization that is based on manger’s incentives to increase their wealth; however, this will be shouldered by other parties within and beyond the organization ( 1997). When they employ fraud, they can manipulate accounting methods providing a tampered profits and performance ratios. According to the survey of (1997), most managers are remunerated from the profits or ROA of their respective firms. In effect, executives will not only impress employees to undergo option grants but as well impress the investors to provide higher incentives believing that the firm is doing well.
Further, (1987) showed that restrictive covenants formed by corporate debts are surmountable by fraud to improve accounting numbers. The process will begin after executives have manipulated financial ratios permissible to the constraints of creditors. In effect, the firm can enjoy strategic actions it cannot implore when the manipulation did not take place. In return, the firm can implement strategies that will ultimately lead to profitability and growth in either prospective or actual sense. When this information is delivered to employees, they will think that stock options are attractive investments. They will purchase stocks unknowing that they are merely funding the efforts of executives to conceal mismanagement or possible bankruptcy. As a result, executives are rewarded two-fold. They can manage the firm with the support of creditors and implementing strategies with employees in full support due to the stock options the latter is currently holding. The cover-up ultimately leads effective fraud on the part of executive whose incentives goes beyond remuneration rather long-term employment, promotion and fame within the industry.
In a similar case, political groups can impede strategic actions of the firm if it reports high earnings or disclose issues pertaining to adverse external effects of their operations (1997). The government may impose tax sanctions or legal remedies on tax evasion while environmental groups can boycott its products when informed about negative externalities (like oil spills). These situations have their adverse impacts in both short-term and long-term existence of the company. In effect, fraud to accounting methods can result to lack of disclosure and computational manipulation to arrive at a standard level of accounting reports. This is why the study of and (1996) found that firms with environmental disclosures still used them for corporate image building. As a result, similar to the benefits of corporate ability to bypass creditor restrictions, the firm can induce its strong business outlook to employees deepening the need of the later to resort to option grants. Executives can distort the likelihood of disruptions from external actors from a major mental lapse in decision-making through designing accounting methods that can hinder such mistake.
On the other hand, under efficiency perspective, the efficiency of the contracting parties or transactions at hand is pursued to end at a minimum agency cost. According to (1999) accounting alternatives are adopted by executives because it reflects the underlying and true performance of corporate assets (). This makes fraud selection for executives ineffective, if not, legally impaired. In this case, risk taking is the more strategic choice for executives to maximize their incentives. For example, there are different methods to compute for depreciation or amortization. When this will be related to stock options, executives have minimal control over the options due to the absence of fraud. In effect, it is left to accept the repercussions of the market. Although this is ambiguous making a less enthusiastic employee to involve their investment in options, this can be an effective mechanism keep employees and executives “unattached” to corporate performance.
Due to this, executives will not be pressured to take unethical accounting practices. One incentive of this is that employees may see the worth of their executives that can induce corporate cohesion. By doing so, executives can freely implement their strategies and run the organization more smoothly. Though this, they can rip the benefits of fraud tactics through similar economic benefits plus the recognition they can derive from complimenting and idolizing employees. They can extend affect their investment decision in the long-run which inevitably acquire employee’s trust. By this time, executives can opt to apply fraudulent actions as they wish. Another incentive is that accounting best practice can be awarded to the company by external actors as well as investors. In effect, executives can go away from unethical practices and manipulation that can minimize the costs of hiring additional skilled accountants and the cost of “greasing” to auditors, politicians and other colluding parties.
Conclusion
There are a number of learning contemporary firms should adapt from the experience of Enron. One is of the most plausible learning is voluntary disclosure. This can be the most problematic and confidential of all administrative tasks as it is directly related to strategy and structure a firm has. The procedure can also aggravate the position of executives and the firm itself. However, users of corporate information are not demanding the whole truth rather the relevant ones. White lies do exist but abuse of this angelic-cloak to evil makes the cloak immaterial with regards to the excessiveness of evil. As discussed in the earlier topic, stock price does not readily emit the effects of unethical accounting practice. In effect, to prevent over-speculation and omission of EMH, the firm should disclose change in accounting policies for user reference not only for awards sake but for maintaining is strategic position in an efficient capital market. Voluntary disclosure can also positively impact the distorting effects of information asymmetry to corporate results and relations. Employees and shareholders can have some level of open communication with executives that can minimize resistance to change and support for growth and strategies. Executives can be seen as good shepherds and would be awarded accordingly. This admonition is reflected by the dual benefits of executives (that is, both monetary and non-monetary) when efficiency perspective is adapted as a strategic framework not merely on employee stock options but more importantly on managerial planning and implementation.
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