For each of the following, identify whether categorize each as ethical, economic
ID: 447833 • Letter: F
Question
For each of the following, identify whether categorize each as ethical, economic and/or legal as appropriate (briefly explain your answer):
o Enron’s actions of deceiving shareholders by shifting debts from their balance sheet
o Arthur Andersen’s ordering the shredding of documents related to their transactions with Enron
o Height and weight requirements for a police force candidate o Tobacco company warnings on labels
o Chic-Fil-A’s policy of being closed on Sunday
o The creation of a website where users can download music for free by sharing files with other users
o Installation of an anti-pollution device
o Smith and Wesson’s addition of safety features to its handguns
o Ben & Jerry’s distribution of free ice cream in a community
o Moving a company overseas because another country has weaker environmental or employment laws
o Pulling a product from a shelf when it is discovered that there is a product defect
Explanation / Answer
Kenneth Lay was Enron's Chief Executive Officer (CEO) since 1985. Lay gave up his position in early 2001 to Jeffrey Skilling, but was re-elected in August 2001 when Skilling resigned. Under pressures from creditors, Lay resigned in January 2002. Skilling reported that he left due to personal reasons after more than ten years with Enron. Lay and Skilling allegedly played major roles in the bankruptcy, but did not have a direct impact on the financial reporting and auditing issues. • Andrew Fastow was Enron’s Chief Financial Officer (CFO) until October 2001, when Lay fired him. Fastow had the reputation of being a money wizard who constructed the complex financial vehicles that drove Enron’s growth. Since 1993, Fastow created SPEs that permitted accounting deceptions. Fastow plead guilty in a plea-bargaining arrangement with his wife, who was also implicated. • David Delainey was the CEO of the retail and wholesale energy divisions. He plead guilty to insider trading, for knowingly participating in manipulating reported financial performance. • Ben Gilsan, Jr. was treasurer of Enron until he was fired in October 2001, for benefiting personally from one of Enron’s complex SPE investments. He was a former accountant with Andersen and played a key role in accounting-related deceptions. He plead guilty to one count of conspiracy related to financial reporting deception. • Michael Kopper was Fastow’s assistant who was actively and aggressively involved in creating and managing SPEs, and in the accounting deception, along with Ben Gilsan. He plead guilty to a lesser charge and has been cooperating with the government to investigate and prosecute others. • Richard Causey was the chief accountant working under Fastow. He plead guilty to crimes related to unfair financial reporting in a plea-bargaining arrangement in exchange for his information in the prosecution of Lay and Skilling. • Sherron Watkins previously had a senior position at Enron that was eliminated in a downsizing activity. She was later re-hired and played a major role as the so-called “whistle blower” who started the downfall. She had worked several years as an accountant for Arthur Andersen and then moved to Enron where she worked for Andrew Fastow for eight years.
The Practice of Public Accounting and Auditing Public accounting regulation includes rules of professional and ethical conduct, testing and licensing of auditors, and similar items. In Texas, as in other states, regulation of the public practice of auditing includes certifying and licensing public accountants and enforcing rules for professional conduct. An audit opinion may be signed only by a licensed Certified Public Accountant (CPA). The Texas State Board of Public Accountancy, like most of the state boards, is non-activist, meaning it does not actively monitor accounting activity, but instead punishes accountants who violate standards of professional conduct. The SEC requires that SEC registrants must be audited by a CPA licensed by a state. Also, the SEC grants permission for specific accounting firms to represent clients before the SEC. The SEC has relied largely on the states for the regulation and qualification of accountants. Private voluntary professional associations, such as the American Institute of Certified Public Accountants (AICPA), have influence, but no direct role in regulating financial reporting and auditing. Historically, however, the AICPA had more influence on the practice of public accounting than it now has.
FINANCIAL REPORTING PRINCIPLES AND DISCLOSURES US federal law requires publicly traded companies to present financial reports in accordance with GAAP, and the SEC has the authority to establish GAAP. Rather than exercising this right, the SEC has relied on other organizations to set financial reporting standards under its oversight. The evolution of written GAAP is presented in Exhibit 6. Currently, the Financial Accounting Standards Board (FASB) establishes GAAP for publicly traded companies. The FASB began as a private-sector organization but has evolved into a quasi-public organization supported by the US federal government and by sales of publications. In the US, there is no expectation that a company would use the same accounting principles for external financial reporting as for income tax reporting. For income tax purposes, companies tend to minimize taxable income. Thus, it is common and ethical for companies to report less taxable income than financial statement income. This differs from a substantial number of other industrialized countries in which income tax reporting and financial reporting are expected to be the same, and failure to report the same amounts would be unethical and usually illegal. Nature of US GAAP GAAP in the US are a complex set of principles, opinions, and statements, both unwritten and written, that have evolved over time. Some, such as the principles of fairness, conservatism, full disclosure, and entity, and basic concepts such as bad debts and depreciation, have never been fully committed to writing and are found in written form only in literature written about them, such as textbooks. Written GAAP began in the 1930s as described in Exhibit 6. In addition to FASB statements, certain documents of the FASB, e.g. Emerging Issue Task Force (EITF) statements, are interim GAAP until the FASB issues a formal statement, if at all. Also, SEC position statements on financial reporting issues are interim GAAP until a formal pronouncement of the FASB occurs. US GAAP for consolidated financial reporting (group accounting) and the equity method of accounting, which are central to the Enron-Andersen case, are presented in Exhibit
Consolidated Financial Reporting: In the US, consolidated financial reporting (often called “group accounting” outside the US) is required when one entity owns more than 50% of another entity and can control its operations. The only significant condition that would lead to non-consolidation would be lack of control of one entity by another because of ownership of 50% or less, or other legal restrictions on the ability of one entity to control another entity. Consolidated financial reporting is complex and cannot be covered in detail here. Briefly, when entities are consolidated, the impacts of all transactions among them are eliminated and individual items on all financial statements are combined and reported as though a single reporting entity exists. Supplemental disclosures are required about the consolidated entities, principles of consolidation, and related items. Under US GAAP, consolidation of controlled entities is the only acceptable method of financial reporting unless specific conditions indicate non-consolidation. This differs from many countries in which consolidated financial reporting is often viewed as supplemental, or both consolidated and parent company financial statements are presented with equal emphasis. In the US, separate reporting on both a consolidated and non-consolidated basis would be viewed as unfair and misleading. The Equity Method of Accounting: Under US GAAP, the equity method of accounting is used when one entity has a significant influence over another, but not complete control. Significant influence is presumed to exist when one entity owns 20% or more of the equity of another entity, unless evidence exists to the contrary. If ownership is less than 20%, the equity method is required if significant influence of one entity over the other exists, a point that has been reiterated by the SEC in recent years. The equity method is also used when there is more than 50% ownership of one entity by another, but for some reason control is not possible or consolidation is not possible. The impacts of transactions among the related entities are eliminated. Financial Reporting Issues Enron and Andersen presented many financial reporting issues. The case deals only with the major ones: mark-to-market accounting, financial reporting for Special Purpose Entities (SPEs), and reporting of shares issued. Mark-to-Market Accounting. Enron traded futures contracts that are classified as derivatives because they derive their value from an underlying asset. The market for futures reduces the volatility of prices for sellers and for buyers by fixing a price at a future date. Enron reported its derivatives using what it called markto-market accounting. Under this method, rather than the derivative being reported at historical cost, it is reported at fair market value of the underlying asset, which assumes the presence of a well developed market. In the absence of quoted prices from active markets, the prices of similar assets or present value techniques may be used to establish a valuation. How did mark-to-market accounting work at Enron? Assume Enron had two option contracts matched over the same time period for the same amount of a commodity; one contract was to buy the commodity and the other contract was to sell the commodity. Enron would look into the future, assume both contracts were exercised and net the results. After allowing for delivery costs and for reserves for other unforeseen costs, the net income (loss) was estimated over the life of the matched contracts. Then this estimated net income (loss) was discounted for the time value of money, to its present value and recorded as a gain (loss). The method required that each year the estimated future earning be re-estimated and marked up or down. At Enron, the earnings reported under mark-to-market accounting were easy to manipulate because active markets did not exist for contracts that sometimes had terms as long as 20 years. So it was necessary to estimate future earnings. Enron controlled the estimation of its earnings, earnings which were recognized for the entire term of the contract in the first year of the contract. The assumption is that earnings are created by securing contracts rather than by rendering performance on contracts. One advantage for Enron’s management of immediate recognition of earnings was that executive compensation, which was based on earnings, was inflated. Enron exacerbated many problems by using mark-to-market accounting. Because earnings were recognized immediately for the entire life of the contract, a short-term focus was encouraged and earnings were volatile. Additional contracts had to be sold in the immediate short-term to report any earnings. So Enron expanded mark-to-market accounting to trading in electricity, broadband, fuel additives, and other items that were not commodities, such as deferred tax benefits. For many of these commodities there was no active market, even in the short-term. Because, in many cases, it is doubtful the underlying assets existed, it appears Enron reported fictitious earnings. A major problem was that these estimated earnings did not generate liquidity; cash flow from actual execution of the contracts lagged far behind the recognition of earnings. The risk was enormous. If the market reversed, mark-to-market accounting required the recognition of losses, possibly enormous losses. A huge gap opened between realistic estimation of earnings and Enron’s estimations based on aggressive assumptions about interest rates, continuing viability of other parties to contract, taxes, regulations, technology, demand, etc. When changing market conditions necessitated a mark down and the recognition of a loss, Enron hid, delayed or ignored the loss. Andersen apparently did not question any of the values assigned to the contracts or object to tactics to hide, delay or ignore losses. Some of Enron’s most abusive SPEs were created to avoid reporting mark-to-market losses.SPEs are typically created for purposes such as owning and leasing real estate. Enron had over 3,000 SPEs, many times more than any other company. Initially, some SPEs were legitimate for risk management. However, the vast majority of the SPEs in the years preceding bankruptcy were used to manipulate financial reports. The SPEs almost always had complex structures with interlocking ownership and with Enron sometimes holding an equity interest. The CFO of Enron and/or other employees held equity interests. Senior executives or other employees of Enron managed and operated the activities of the SPE while being paid salaries by Enron and receiving no compensation from the SPE. Enron’s board of directors exempted its CFO from Enron’s conflict of interest policies. As a result, he was able to control both sides of transactions and enrich himself. Many of the financial reporting issues at Enron related to the concept of entity -- failure to consolidate entities, selective use of the equity method of accounting for entities, and failure to eliminate the effects of transactions among the entities. As a result of these irregularities, Enron manipulated its financial reports in several ways, including the following: • Enron did not report debt on its balance sheet. Through collaboration with major banks, SPEs borrowed money, often with direct or indirect guarantees from Enron. The cash was used to benefit Enron, but was not necessarily transferred to Enron. Enron did not report debt on its financial reports. It did not disclose the contingent liability for the debt as required by GAAP. Various methods described next were used to transfer the cash and further manipulate financial reports. • Enron had investments in companies (which were not SPEs) that it consolidated or reported on the equity method. When the investments began to show losses, they were transferred to SPEs so Enron would not reflect the losses. Enron did not consolidate or report the SPEs on the equity method, and thus avoided reporting the loss. Often the “sale” of the investment to the SPE generated a reported gain, and a cash payment from the SPE to Enron to pay for the investment could be used to transfer borrowed cash. This process allowed Enron to manipulate its reported cash flow by disguising cash from borrowing as cash flow from sale of investments. • Enron sold services to SPEs for large amounts in order to inflate its sales revenue and income. Because Enron did not use the equity method of accounting, the cost to the SPE was not reflected by Enron. The cash payment from the SPE to Enron for the “services” could be borrowed cash. Thus Enron would report cash flow from operations rather than from borrowing.
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