Practical Application: Identifying Problems with Financial Information

Instructor: Scott Tuning

Scott has been a faculty member in higher education for over 10 years. He holds an MBA in Management, an MA in counseling, and an M.Div. in Academic Biblical Studies.

Business records and reports are always important, but financial documents are unquestionably among the most important. Because financials are often quite complex, the consistency and accuracy of financial information is paramount.

Importance of Financial Information

When compared to other business documents, financial information is perhaps the most complex and consequential. An organization's financial records are used to make determinations about credit, company value, and company performance, among many other important elements. Although there are no aspects of business record-keeping that do not require accuracy and compliance, the requirement related to these characteristics in financial documentation is particularly elevated, since virtually every aspect of the business is affected by financial performance.

In some cases, it's uniquely difficult to verify the accuracy of financial statements because the information is complex, inaccessible, or subject to subjective determinations. Let's look at a scenario that demonstrates the importance of accuracy in financial reporting and the consequences that occur if problems are not identified.

Scenario: Financial Irregularities

It's fairly uncommon for an energy company's name to be a household word, but that's only if the company is not Enron. Enron's financial irregularities represent some of the worst financial reporting practices that the corporate world has ever seen. Before you look at this scenario, consider reviewing the information in the lesson about typical problems with financial information. Once you've reviewed the material, read through the synopsis presented below and be prepared to identify problems with Enron's financial data.

Enron was formed in the mid-1980s, the result of a merger of two smaller companies. Less than 20 years later, the organization was dissolved. In a span of less than two years, between 2000 and 2001, the company's stock value plummeted from just under $100 a share to less than one dollar per share. When that value was lost, many Enron employees who had been heavily invested in the company lost nearly everything when the organization went bankrupt.

The outcome for Enron and its executives was quite rare. Criminal charges were filed against many of the company's executives, and the audit firm employed by Enron found their corporation adjudicated as criminally liable - a status exceedingly rare in the United States.

In an effort to make Enron look more profitable, executives manipulated accounting practices in order to reduce negative information related to finance. Specifically, the company's executives set up multiple shell corporations and special purpose entities, which they then used to conceal corporate debt. This conspiracy led to many individuals both inside and outside the company buying Enron stock based on its strong financial performance when, in fact, the company was far from profitable.

The scope and severity of inaccurate Enron financials was so broad that Congress passed sweeping legislation to enforce higher standards in financial reporting. This included the Sarbanes-Oxley Act.
Enron Logo

Enron wasn't the only major organization to fall as a result of inaccurate financials. One of the United States' most respected, top-five audit firms, Arthur Anderson, was Enron's external auditor, and its failure to identify the irregularities essentially destroyed the organization.

Important Questions

  • Does Enron's spectacular collapse in stock price and value necessarily mean that financial information was inaccurate or went unidentified? Is there any chance that Enron simply experienced an exceptional turn of fate that forced it out of business? Why or why not?
  • The use of shell corporations and fictitious special-purpose entities isn't a new concept in financial fraud. What specific elements of the special-purpose entities should have triggered concerns about Enron's problematic financials?
  • Why did so many shareholders, including major shareholders, feel exceedingly safe when, in fact, disaster loomed on the horizon? If applicable to the reason you gave here, what process or company failed to perform as required by law and practice?
  • Although most people remember the Enron scandal for its willful fraud, not all financial reporting problems are associated with crime or fraud. What other types of financial information irregularities can occur for noncriminal reasons?
  • What entity, individual, or organization is responsible for identifying inaccurate financial reporting of any nature without regard to conspiracy or fraud?

Reflection and Outcome

Although it's possible that Enron simply experienced a terrible turn in financial performance, it's extremely unlikely that a crash in value like this could occur without high-level and complex fraud. Because the use of fictitious entities is often associated with fraud, financials that contain an exceptionally high number of transactions with ambiguous, mysterious, and apparently nonexistent organizations should always stand out as an irregularity in financial reporting.

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