At the beginning of the twenty-first century, there were several high-profile corporate accounting scandals in the United States that resulted in the loss of billions of dollars worth of wealth for investors. The subsequent corporate bankruptcies—most notably Enron, WorldCom, and Adelphia—created a significant public backlash against the way large corporations managed themselves. The US Congress reacted by looking to create new laws that would reform and render corporate accounting practices more transparent and hold executives accountable for the accuracy of their firms’ financial statements. The most comprehensive of these legislative initiatives was the Sarbanes-Oxley Act of 2002 (SOX or SarbOX). This paper will more closely analyze the SOX Act, the forces that created it, and its current impact on corporate accounting practices in the United States.
Keywords: Accounting Fraud; Arthur Anderson LLC; Enron; Generally Accepted Accounting Principles (GAAP); Oxley, Michael; Pro Forma; Public Company Accounting Oversight Board (PCAOB); Sarbanes, Paul; Special Purpose Entities (SPE); WorldCom
In the world of business, enterprises can rise and fall with great frequency and with varying degrees of rapidity. Some are the unlikeliest of success stories, such as the sudden growth of a small Vermont ice cream shop called Ben & Jerry's into one of the most profitable ice cream businesses in the world. Others, such as finance giant Lehman Brothers, experienced a collapse that was as shocking as it was economically devastating.
In many cases, business success and failure are the result of the conditions of the markets in which they operate. Shifts in consumer demand and economic recessions or booms have a major influence on a business's viability. Then again, there are circumstances in which a business enterprise fails not as a result of external conditions but of the organization's internal decisions and policies. The Enron scandal that was revealed in 2001 provides an example, since that organization's collapse was created largely by deceptive accounting practices and mismanagement. The fact that so many businesses and investors were linked to Enron before it folded meant that its demise sent shockwaves throughout the global economy and further weakened an already anemic US economy that was struggling to recover after the terrorist attacks of September 11, 2001.
Enron's bankruptcy was one of many high-profile corporate collapses that occurred at the beginning of the twenty-first century. These corporate downfalls created a significant public backlash against the way large corporations managed themselves. Congress reacted by looking to create new laws that would reform and render more transparent corporate accounting practices. The most comprehensive of these legislative initiatives was the Sarbanes-Oxley Act of 2002 (SOX).
Enron: An Epic Collapse
The rise of Enron and similar energy sector companies can largely be traced to energy deregulation in the 1990s. Enron was founded in 1985 as a traditional energy company, selling natural gas to distributors and businesses ("What Happened," 2002). The brainchild of founder Kenneth Lay was a merger of two Texas natural gas pipelines, Houston Natural Gas and InterNorth, whose combined ownership of pipelines spanned thirty-seven thousand miles. At the time, prices for natural gas and other utilities were fixed and regulated, and most transactions were based on preset prices established in contracts. This condition gave Enron stability and a foundation on which growth could take place. In the mid-1990s however, stability turned to great potential, as deregulation led to more flexible contract arrangements and spot pricing (a market-derived price that is quoted within two days of trading). Enron, as the largest interstate network of natural gas pipelines, was well positioned to profit from deregulation (Healy & Palepu, 2003).
As Enron's profits grew, it began to diversify its interests, acquiring electricity, paper and water plants, among other holdings, before the cracks began to show. By 2000, the company had become a powerhouse with a business model that others emulated. Enron's reputation on the capital markets (which help generate monies for business enterprises) was unparalleled. That positive perspective continued through the summer of 2000, when the company's stock held a fifty-two-week high of $90.56. However, between 2000 and 2001, Enron's stock value began to fall. On August 14, 2001, Enron’s president and chief executive officer, Jeffrey Skilling, abruptly resigned, citing personal reasons. The company's value on Wall Street was falling precipitously, which some at the time attributed to Enron's breakup with Blockbuster on a video-on-demand broadband Internet deal as well as an expensive fight with the Indian government over the construction of a power plant in that country (Forest, 2001).
Enron's shortcomings did not send up many red flags at the time. Such poor performance was explained by these two issues as well as the difficulties of an economy that was settling into recession. However, in October 2001, Enron chair Kenneth Lay announced that Enron had lost an astounding $638 million in the third quarter and disclosed a reduction in shareholder equity of $1.2 billion. The media seized on the news, and one week later Lay acknowledged that the Securities and Exchange Commission (SEC) was launching a formal investigation of Enron's use of special purpose entities (SPEs) and the company’s relationship with accounting giant Arthur Anderson LLC (Sridharan, Dickes & Caines, 2002).
Special Purpose Entities (SPE)
Special purpose entities (SPEs) have been used by businesses since the 1970s and were, until the Enron scandal, widely accepted as legitimate accounting tools. An SPE is created by a business by transferring assets to it in order to carry out a specific activity or transaction. However, the accounting for an SPE is separate from the mother company—any activity conducted by an SPE is not reflected on the main business organization's balance sheet. As a result, the only liability the "sponsor" corporation has to the SPE in the event of loss is what was originally placed in the SPE. Meanwhile, the corporation's main list of assets and liabilities does not include the activities of its SPEs. Generally accepted accounting principles (GAAPs), which are a set of universally accepted accounting policies, allow for the establishment of SPEs as long as a minimum amount of capital is infused into the SPE by the parent company and the SPE's owner must take responsibility for its operation (Soroosh & Ciesielski, 2004).
The use of SPEs by Enron created an extremely complex and unclear financial image for observers. The casual observer might see the balance sheet as indicative of a major corporation undertaking little risk but generating sizable revenues. However, the failures of Enron's risky SPEs were not immediately evident, primarily because Enron was not expected to attach such losses to its own balance sheets. It was only revealed later that Enron's executives had in fact fraudulently reported profits but not debts, inflating its stock value and enabling it to obtain some capital from ignorant financial institutions and other investors ("Enron: Timeline," 2005). In November 2001, Enron admitted that, through its use of SPEs, it had inflated the company's profits and hidden its debts. Andersen, which oversaw Enron's accounting, had allegedly turned a blind eye to the Enron scheme during that period and even destroyed documents that would likely have proven damning to Enron's case. In December, Enron filed for bankruptcy, a humiliating end to one of the largest corporations. Then again, although the company was virtually dead, Enron's demise would only be the beginning. A major, high-profile investigation was launched shortly after the "funeral."
Setting the Stage for Sarbanes-Oxley
In May 2006, a Texas jury found Kenneth Lay and...
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