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Management of Financial Institutions

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Management of Financial Institutions - MGT 604
Lecture # 43
The Collapse of ENRON
Only months before Enron Corporations bankruptcy filing in December 2001, the firm was
widely regarded as one of the most innovative, fastest growing, and best managed
businesses in the United States. With the swift collapse, shareholders, including thousands
of Enron workers who held company stock in their 401(k) retirement accounts, lost tens of
billions of dollars. Investigations of wrongdoing may take years to conclude, but Enron's
failure already raises financial oversight issues with wider applications. This lecture briefly
examines the accounting system that failed to provide a clear picture of the firm's true
condition, the independent auditors and board members who were unwilling to challenge
Enron's management, the Wall Street stock analysts and bond raters who missed the trouble
ahead, the rules governing employer stock in company pension plans, and the unregulated
energy derivatives trading that was the core of Enron's business. Formed in 1985 from a
merger of Houston Natural Gas and Inter-north, Enron Corporation was the first nationwide
natural gas pipeline network. Over time, the firm's business focus shifted from the regulated
transportation of natural gas to unregulated energy trading markets. The guiding principle
seems to have been that there was more money to be made in buying and selling financial
contracts linked to the value of energy assets (and to other economic variables) than in
actual ownership of physical assets. Until late 2001, nearly all observers ­ including
professional Wall Street analysts ­ regarded this transformation as an outstanding success.
Enron's reported annual revenues grew from under $10 billion in the early 1990s to $101
billion in 2000, ranking it seventh on the Fortune 500. Several committees in the House and
Senate have held or plan to hold hearings related to Enron's fall. The Justice Department is
conducting a criminal investigation. The challenge for financial oversight, however, does
not depend on findings of wrongdoing. Even if no one at Enron did anything improper, the
swift and unanticipated collapse of such a large corporation suggests basic problems with
the U.S. system of securities regulation, which is based on the full and accurate disclosure
of all financial information that market participants need to make informed investment
Auditing Issues
Federal securities law requires that the accounting statements of publicly traded
corporations be certified by an independent auditor. Enron's outside audits have received
much attention. While external audits do not prevent corporations from making financial
mistakes, let alone bankruptcy, problems with recent Enron audits may have contributed to
both the rapid rise and the sharp fall in its stock price. Outside investors, including financial
institutions may have been misled about the corporation's net income (which was
subsequently restated) and contingent liabilities (which were far larger than generally
known). The auditor, Arthur Andersen, has admitted some mistakes. Andersen fired the
partner in charge of Enron audits on January 15, 2002, and Enron dismissed Andersen on
January 17. One issue is whether Andersen's extensive consulting work for Enron may have
compromised its judgment in determining the nature, timing, and extent of audit procedures
and in asking that revisions be made to financial statements, which are the responsibility of
Enron's management. Questions have also been asked about Andersen destroying
documents and e-mails related to its audits. Oversight of auditors has primarily rested with
the American Institute of Certified Public Accountants (a nongovernmental trade group) and
state boards of accountancy. On January 17, 2002, the Chairman of the Securities and
Exchange Commission (SEC) proposed a new oversight board that would be responsible for
disciplinary actions.
Management of Financial Institutions - MGT 604
Accounting Issues
The Enron controversy involves several accounting issues. One concerns the rules
governing whether the financial statements of special purpose entities (SPEs) established by
a corporation should be consolidated with the corporation's financial statements; for certain
SPE partnerships at issue, consolidation is not required if among other things an
independent third party invests as little as 3% of the capital, a threshold some consider too
low. A second issue concerns the latitude allowed in valuing derivatives, particularly non-
exchange traded energy contracts. Third, there are calls for improved disclosure, either in
notes to financial statements or a management discussion and analysis, especially for
financial arrangements involving contingent liabilities. Accounting standards for
corporations are set by the Financial Accounting Standards Board, a nongovernmental
entity, though there are also SEC requirements. (The SEC has statutory authority to set
accounting standards for firms that sell securities to the public.)
Pension Issues
Like many companies, Enron sponsors a retirement plan ­ a "401(k)" ­ for its employees to
which they can contribute a portion of their pay on a tax-deferred basis. As of December 31,
2000, 62% of the assets held in the corporation's 401(k) retirement plan consisted of Enron
stock. Many individual Enron employees held even larger percentages of Enron stock in
their 401(k) accounts. Shares of Enron, which in January 2001 traded for more than
$80/share, were worth less than 70 cents in January 2002. Consequently, the company's
bankruptcy has substantially reduced the value of its employees' retirement accounts. The
losses suffered by participants in the Enron Corporation's 401(k) plan have prompted
questions about the laws and regulations that govern these plans.
Corporate Governance Issues
The role of a company's board of directors is to oversee corporate management to protect
the interests of shareholders. However, in 1999 Enron's board waived conflict of interest
rules to allow chief financial officer Andrew Fastow to create private partnerships to do
business with the firm. These partnerships appear to have concealed debts and liabilities that
would have had a significant impact on Enron's reported profits. Enron's collapse raises the
issue of how to reinforce directors' capability and will to challenge questionable dealings by
corporate managers. Specific questions involve independent or "outside" directors. (Stock
exchange rules require that a certain percentage of board members be unaffiliated with the
firm and its management.)
Securities Analyst Issues
Securities analysts employed by investment banks provide research and make "buy," "sell,"
or "hold" recommendations for the use of their sales staffs and their investor clients. These
recommendations are widely circulated and are relied upon by many investors throughout
the markets. Analyst support was crucial to Enron because it required constant infusions of
funding from the financial markets. On November 29, 2001, after Enron's stock had fallen
99% from its high, and after rating agencies had downgraded its debt to "junk bond" status,
only two of 11 major firm analysts rated its stock a "sell." This performance added to
concerns that were raised in 2000 in the wake of the "dot com" stock crash.
Derivatives Issues
The core of Enron's business appears to have been dealing in derivative contracts based on
the prices of oil, gas, electricity and other variables. For example, Enron sold long-term
contracts to sell energy at fixed prices. These contracts allow the buyers to avoid, or hedge,
the risks that increases (or drops) in energy prices posed to their businesses. Since the
markets in which Enron traded are largely unregulated, with no reporting requirements,
little information is available about the extent or profitability of Enron's derivatives
Management of Financial Institutions - MGT 604
activities. Did Enron earn money from dealer commissions and spreads, or was it actively
speculating on future price trends? Speculative losses in derivatives, perhaps masked by
"creative" accounting, could have contributed to the firm's downfall. On the other hand, the
trading operations may have been profitable and trouble free, and Enron's financial
difficulties the result of other unrelated operations. Enron's collapse raises the issue of
supervision of unregulated derivatives markets.
Corrective Actions
The collapse of Enron proved to be a valuable wake-up call to a number of affected groups.
The following actions have already been taken by private organizations: The Business
Roundtable, composed of the chief executives of about 150 large firms, urged corporations
to adopt a number of voluntary changes in corporate governance rules, including that a
``substantial majority'' of corporate boards be independent ``both in fact and appearance.''
The New York Stock Exchange and the National Association of Securities Dealers
approved major additions and changes in the rules for accounting, auditing, and corporate
governance as necessary conditions for listing of a corporation's stock for trade on the
exchange. The major continuing uncertainty is how the exchanges will monitor and enforce
these rules. The International Corporate Governance Network, institutional investors that
control about $10 trillion in assets, has approved a set of international standards for
corporate governance that its members would use their voting power to promote. Standard
and Poor's, one of the three major credit-rating agencies, has developed a new concept of
``core earnings'' as a measure of earnings from a company's primary lines of business.
Compared with earnings as defined by the generally accepted accounting principles
(GAAP), for example, the S&P measure will exclude gains and losses from a variety of
financial transactions. S&P plans to report this measure of earnings for all publicly held
U.S. companies.
Table of Contents:
  1. Financial Environment & Role of Financial Institutions:FINANCIAL MARKETS &INSTITUTIONS
  2. FINANCIAL INSTITUTIONS:Non Banking Financial Companies
  3. CENTRAL BANK:Activities and responsibilities, Interest Rate Interventions
  4. POLICY INSTRUMENTS:Open Market Operations, Capital Requirements
  5. BALANCE OF TRADE:Balance of Payments Equilibrium, Public Policy and Financial Stability
  6. STATE BANK OF PAKISTAN:History, Regulation of Liquidity, Departments
  10. STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS (Contd.):Human Resources Department
  13. PAKISTAN ECONOMIC AID & DEBT:Macroeconomic Stability, Strengthening Institutions
  14. INCREASING FOREIGN DIRECT INVESTMENT:Industrial Sector, Managing the Debt
  15. ROLE OF COMMERCIAL BANKS:Services Typically Offered by Banks, Types of banks
  16. ROLE OF COMMERCIAL BANKS:Types of investment banks, The Management of the Banks
  17. ROLE OF COMMERCIAL BANKS:Public perceptions of banks, Capital adequacy, Liquidity
  19. ROLE OF COMMERCIAL BANKING:Private Deposit Insurance,
  20. BRANCH BANKING IN PAKISTAN:Remittances, Online Fund Transfer
  22. Mutual funds:Types of international mutual funds, Mutual funds vs. other investments
  23. Mutual Funds:Criticism of managed mutual funds, Money Market Fund
  24. Mutual Funds:Balanced Funds, Growth Funds, Specialized Funds, Measuring Risks
  25. Mutual Funds:Cost of Ownership, Redemption Fee, Reports to Shareholders
  26. Mutual Funds:Internet Fraud, The Pyramid Scheme, How to Avoid Investment Fraud
  27. Mutual Funds:Investing In International Mutual Funds, How to Pre-Select a Mutual Fund
  28. Role of Investment Banks:Recent evolution of the business, Possible conflicts of interest
  29. Letter of Credit:Elements of a Letter of Credit, Commercial Invoice, Tips for Exporters
  30. Letter of Credit and International Trade:Terminology, Risks in International Trade
  31. Foreign Exchange & Financial Institutions:Investment management firms, Exchange Traded Fund
  32. Foreign Exchange:Factors affecting currency trading, Economic conditions include
  33. Leasing Companies:Basic Purpose of Leasing, Technological Benefits
  34. The Leasing Sector in Pakistan and its Role in Capital Investment
  35. Role of Insurance Companies:Indemnification, Insurer’s business model
  36. Role of Insurance Companies:Life insurance and saving
  37. Role of financial Institutions in Agriculture Sector:What is “Revolving Credit Scheme”?
  38. Agriculture Sector and Financial Institutions of Pakistan:What is SMEs
  39. Can Government of Pakistan Lay a Pivotal Role in this Sector?:Business Environment
  40. Financial Crimes:Process of Money Laundering, Terrorist Financing
  41. DFIs & Risk Management:Managing Credit Risk, Managing Operational Risk
  42. Banking Fraud & Misleading Activities:Rogue Traders, Uninsured Deposits
  43. The Collapse of ENRON:Auditing Issues, Corporate Governance Issues, Corrective Actions
  44. Classic Financial Scandals:Corruption, Discovery, Black Wednesday