A number of accounting scandals have occurred within the past years, the effect of which will continue to be remembered by the general public. These scandals were blamed on series of factors, ranging from poor corporate governance to the compensation-plan of top management. Two of the most spectacular and popular scandals were Polly Peck in the UK in 1990 and Enron in the US in 2001. These two scandals where different in their own ways, but they end-results were similar - distraught shareholders lost their entire life savings, employees lost their jobs, creditors did not get paid back, and lots more.
NATURE OF SCANDALS, PERPETRATORS AND THEIR ROLES
In 1980, a company known as Restro Investment which was controlled by Asil Nadir bought 58% of the shares of Polly Peck, a small company in the textile industry for £270,000. With this, he had control over the company and within 10 years of purchase, Polly Peck grew into a big company (Wearing, 2005). Within the years 1982 - 1989, turnover, pre-tax profit, and net assets rose from £21 million to £1.16 billion, £9 million to £161 million, and £12 million to £845 million respectively (Jones, 2011). However, despite its excellent results, Polly Peck was unable to pay its creditors. What was surprising was that although Nadir had only 25% of the shares as at 1989, he still controlled and dominated the board and the company as a whole. Nadir extracted cash from Polly Peck and transferred it into its subsidiary companies like Uni-Pac before he eventually transferred it out for his personal use. These withdrawals would appear in Polly Peck's accounts as amount owed by subsidiaries and would subsequently be cancelled out as inter-company balance (Jones, 2011). An investigation by the Serious Fraud Office (SFO) also revealed that Polly Peck cooked up its assets in some of its subsidiaries so as to cancel out the amount owed by these subsidiaries to Polly Peck. What also made the scandal worse were the accounting policies adopted by Polly Peck which were in accordance to the requirement of accounting standards at that time. In 1983, Polly Peck adopted the SSAP 20 (Foreign Currency Translation) and chose to use the average rate to translate its profitless items. Thus, when it restated its 1982 financial statement in line with SSAP, there was an increase of £2.7 million in turnover and £1.5 million in net assets for that year only. Hence, Polly Peck continued with its average method in translating profit and loss items, and from 1983-1989, Polly Peck made a profit before interest and tax of £599 million and within the same period, debited £415 million to the profit and loss account due to the movements on exchange. Of this £415 million, £56 million was as a result of the use of the average method in converting its profit and loss items, while the remainder was due to the translation of its opening net investments. Hence, Polly Peck continued to grow each year, as movement on the exchange was adverse.
Andrew Fastow, the CFO at Enron, was behind the creation of Special Purpose Entities (entities set up to carry out certain activities) into which Enron could dump debts and generate income, thereby deceiving investors on the real nature of their capital structure. With this, he was able to hide debt worth over $1 billion in the SPEs. Also, due to the fact that the US GAAP stipulated that such SPEs need not be consolidated if at least 3% of its total financing came from independent equity holders, Enron had the perfect excuse not to consolidate their statements with those of their SPEs. However, it was later discovered that the equity was not actually owned by independent third party, but by Enron itself. Therefore, Enron should have consolidated the SPEs in the first instance. Also, Enron's CEO, Jeffrey Skilling pleaded with regulators to enable the company use the mark- to-market accounting method, thereby enabling him to put down $65 million of profit for his department. This was solely done to enable him meet analysts' expectation and also obtain the promised compensation of 3% of the value of his department's business.
Enron's board of directors fell short of their responsibilities by setting aside the code of ethics and allowing illegal partnership to take place. Also, the board did not follow through the investigation carried out by the finance department regarding the compensation of Fastow. Although the board argued that they had no knowledge about what was going on, the Powers Report stated that the board had failed in its oversight duties (Gown & Abelson, 2002).
The audit committee at Enron had every right to investigate the dealings that Enron was going into in order to stop it from the onset. However, they did not ask any questions nor did they scrutinize the boards (Peel & Hill, 2002).
Analysts on the other hand compounded the fraud by backing Enron and encouraging people to buy their shares even when the stock price was falling. Whenever analysts opted to say otherwise, they would run into problems with their employers. This was the case of Chung Wu who was sacked by his manager Price Webber because Chung sent an email to Enron's investors telling them to "take some money off the table" as the financial situation at Enron was not looking good.
DETRIMENTS TO STAKEHOLDERS OF THE ENTITIES
One of the negative effects of accounting frauds is the disadvantage it usually has on stakeholders like creditors, employees, shareholders, and any other person or group of people who have a beneficial interest in the firm. As regards Polly Peck, it was revealed that they owed over 1.3 billion to creditors. And to make matters worse, these creditors only received 4 pence for every pound they were owed. Also, most shareholders as well as thousand s of pensioners lost all of their investment. Ten thousands of employees also lost their jobs.
As with employees at Enron, they were deceived into believing that the company was still doing well and were further prevented from selling their stock or diversifying their portfolio even while the top executives were selling theirs. They watched haplessly as their life savings vanished from their eyes. As a result of the scandal, the reputation of top management was destroyed and it led to some of them like Jeffery Skilling, Andrew Fastow, and Kenneth Ley being persecuted and subsequently imprisoned. Regarding the investors at Enron, both institutional and individual investors lost a huge amount of their investment because they were deceived into believing that the firm was still performing well.Regarding executives and senior management, unethical practices were paramount in Enron whereby those who played along were showered in compensations and rewards, while those who challenged the dealings were persecuted.
GOVERNANCE ROLES THE BOARDS HAVE OVER THE ENTITIES
The board of directors are those who are responsible for ensuring that the company is being managed by the managers in the interest of the shareholders, and they are responsible for holding the ethical code of the organization. Board of directors are also meant to oversee accounting practices in order to ensure compliance with accounting standards, review remuneration schemes of top executives in order to prevent conflict of interest arising, and ensure independence of company's auditors by rotating the audit firm after every few years and preventing the audit firm from providing both internal and external audit services.This was not the case at Enron as the improper governance of its board of directors was one of the major problems which led to its fall.
It can also be said that there was weak governance at Polly Peck as Nadir was able to move large sums of money without any employees or directors questioning him. This was probably due to the fact that Nadir was acting as both chairman and CEO, thereby giving him absolute power and control and also due to the lack of effective control system within Polly Peck's head office in London. The control systems were so weak to the extent that even the need for dual signatures on bank withdrawals was absent.
ROLE OF EXTERNAL AUDITORS AND AN ASSESSMENT AS TO WHETHER THEIR AUDIT DUTIES WERE FULFILLED
The auditors of Polly Peck were Erdal & co. (Turkish subsidiaries auditors) and Stoy Hayward (UK- based group auditors). Erdal & co. collaborated with Polly Peck in the manipulations of their accounts and this led to the exclusion of Erdal partners from the Institute of Charted Accountants of England and Wales, while Stoy Hayward was criticized on the basis of inefficiency in the assessment of Erdal in carrying out the audit of the Turkish subsidiaries of Polly Peck; inefficiency in reviewing Erdal's working papers; and failure to investigate the causes of the abnormal growth in its subsidiaries.
SAS 82 requires external auditors to look for financial and non-financial incentives as indicators of fraud while carrying out their audit duties. According to Apostolo et al (2001), there were two of these non-financial incentives present at Enron which were ignored by Andersen. They were: compensation being linked to aggressive accounting practices, and management's nonchalant attitude over the internal controls. Also, Andersen did not report the tax avoidance scheme used by Enron. From another point of view, the drastic changes in the financial statements of Enron were supposed to have made the external auditors suspicious. Such as:
Why the operating income, Earnings per share (EPS), and gross margins fluctuated greatly between the years 1997- 2000
Why the stock price increased tremendously in 2000, when the EPS only increased by a little percentage, and in fact gross margin percentage dropped from 13.3% to 6%.
With all this, it can be said that both Stoy Hayward and Andersen did not take a close look at the red flags which suggested that there could be fraud at Polly Peck and Enron respectively.
AUDITORS CONFLICT OF INTERESTS
Auditors' conflict of interest refers to a situation whereby the personal interest of auditors conflicts with their fiduciary duties, hence having undue influence on their responsibilities and preventing them from acting in the best interest of shareholders. This conflict of interest can be real or perceived. Arthur Andersen was Enron's external auditor, providing it with external audit services, internal audit services and consultancy services. Coupled with the fact that a large amount of the firm's fee was from its non-audit work rather than its audit work, it can be stipulated that there was a threat to the independence of Arthur Andersen, thereby leading to a conflict of interest. In addition, the relationship between Enron and Andersen's employees was so close that at Enron's office in Houston, it was difficult to differentiate Enron's employees from Andersen's. To worsen the situation, Enron's internal audit staff became Andersen's staff when Enron's internal audit division was taken over by Andersen. This depicts a true scenario of conflict of interest as the independence position of the auditors has been compromised. Though Andersen argued that this relationship did not in any way affect their independence position, it still was against the AICPA's (American Institute of Certified Public Accountants) code of professional conduct requirement that external auditors should at all times give the "appearance of independence" in order to give credibility to their work.
In the case of Polly Peck, the conflict of interest that arose was on the part of Coopers & Lybrand, who were responsible for the administration and receivership of Polly Peck. There was a conflict of interest as they had shares in Polly Peck, audited its subsidiaries, served as advisors to the directors and reported on the company's prospectus (Sikka, 2004). Also as Polly Peck was one of Stoy Hayward's most established customers, there was the possibility of conflict of interest as Stoy Hayward would not want to lose a major source of their income.
LESSONS LEARNT FROM THE SCANDALS
Before the collapse of Polly Peck, stakeholders and the general public found it hard to understand how the company was making its money even though it had no cash, but no one was doing or saying anything about it, and there were no questions asked. Therefore, an important lesson learnt is that questions should be raised and investigations should be carried out when there is doubt, in order to identify the possibility of a fraud before it's too late. Also, Asil Nadir was acting as both the chairman and CEO of Polly Peck, thereby having so much authority and power which means there was hardly any segregation of duties, making it difficult to recognize the fraud from the beginning. Hence, another lesson learnt is to have two different individuals acting as CEO and chairman, as stated in the Cadbury report.
One of the lessons learnt from the Enron scandal is that auditors should be rotated after a certain number of years so as to maintain their independence. In the case of Enron, Andersen was its auditor since its inception in 1983, hence, the close relationship between Andersen and Enron. This probably led to Andersen overlooking the irregularities of Enron.
Also, it was learnt that there should be a check on bonus-based compensation for employees, as this could have made them implore any means to achieve the stated bonus, even though it could be to the detriment of the company in the long run.
How were these lessons incorporated into subsequent codes on corporate governance? Explain what these codes aimed to achieve
As a deterrence for the scandal in Enron occurring in future, the Sarbanes Oxley act 2002 (SOX) was introduced. This SOX does not tackle the issue of corporate governance by enforcing code of best practice or principle, but by placing more responsibilities on directors and senior management. For example, the CEO and CFO must certify that to the best of their knowledge that the annual report and quarterly reports do not contain an untrue statement or omission of immaterial fact and that the financial statements and financial information fairly represent, in all material aspects, the true financial condition and results of operations of the company. Therefore, one of the aims of the SOX is to make the CEO and CFO ensure that fraud does not occur, otherwise they will be held responsible and penalized. The act requires all listed companies to have audit committees which will be responsible for determining their audit fees and appointing auditors, thereby ensuring they carry out their work properly. These audit committees must consist of independent directors who must not, in whatsoever circumstance, obtain consulting and non-board fees from the company, thereby strengthening their independence from the company. Audit firms are prohibited from serving as auditors of a particular firm for a year, if it so occurred that the CEO, CFO, or chief accounting officer of the audited firm has in any way participated in the company's audit while employed by the audit firm, thereby avoiding any conflict of interest on the part of auditors.
Another step taken was the establishment of PCAOB (Public Company Accounting Oversight Board) for the introduction of rigid procedures that will safeguard the auditors' independence from management and the regulation of the profession. Also, the PCAOB was put to oversee the audit of public companies in order to protect the interest of investors.
The Cadbury report was published in 1992 after the collapse of some prominent UK companies, including Polly Peck. The collapse was mainly as a result of board oversight and weak governance systems. The Cadbury report is a report of a committee chaired by Adrian Cadbury which focuses on the arrangement of company boards and accounting systems to reduce corporate governance risks and failures. It recommends the establishment of a non-statutory code of best practice and governance issues in listed companies. This was known as the combined code which was to become the backbone of corporate governance. The code recommends that board of UK corporations or publicly traded companies should include at least three outside non-executive directors effective internal control systems should be put in place, there should be transparency in its financial reporting, and that positions of Chairman of the Board (COB) and Chief Executive Officer (CEO) be held by two different individuals.
PRINCIPLE BASED CODES VERSUS RULES BASED CODES
It can be said that the codes under the US Code of Corporate Governance (for example, Sarbanes Oxley Act) are rules based while those under the UK Code of Corporate Governance (for example, Cadbury report) are principle based. The US Code of Corporate Governance focuses on quantitative measures such as audit committee and outside directors while the UK Code of Corporate Governance focuses on qualitative measures such as transparency and due diligence. This can be seen in the case of Enron - although it met the quantitative measures of corporate governance, it failed to meet the qualitative measures. The rules based codes can be said to be regulator-led as the SEC are liable for implementing, enforcing and monitoring codes of corporate governance, hence, have a one-size-fits all approach and gives little or no room for creativity, while the principle based codes on the other hand can be said to be shareholders-led as the shareholders have the right to decide on what codes are essential and suitable to guard their interest.
According to Rezaee (2008), the principles based approach is seen to be more effective than the rules based approach due to the fact that it is more flexible and enables the participants of corporate governance, for example auditors, audit committee and directors exercise their professional judgement, thereby, maintaining the reliability and quality of the corporate governance system.
Your views as to whether the corporate governance codes have addressed all the issues raised or whether other areas need to be addressed either through codes or through companies own corporate governance procedures
It can be concluded that though most of the issues regarding the Polly Peck and Enron scandals have been addressed in the codes of corporate governance, the issue of the audit committee has not been fully addressed. Although the SEC requires listed companies to have audit committees, we believe they should be held more responsible and penalized if there is a corporate governance failure in the company which they are overseeing.
