ETH 5900 Module 2 Written Assignment: Legal but Wrong? Enron, Accounting Rules and the Law Example

Approved, Audited and Still Wrong: Law and Ethics in the Enron Collapse

Student Name

Master of Science in Management, Thomas Edison State University

ETH-5900: Ethics for Managers

Mentor Name

Month Day, Year

Approved, Audited and Still Wrong: Law and Ethics in the Enron Collapse

Law and Ethics

Byars and Stanberry (2018) describe law as the minimum standard of conduct a society enforces and ethics as the broader standard of what one ought to do. The two overlap but differ in both directions: some legal acts are unethical, and some ethical acts, such as civil disobedience, may break laws. For managers, the important case is the first. When a practice is legal or approved, people inside an organization can treat the approval as the end of the question. Enron is a study in that mistake. The documentary shows Enron traders profiting from the California electricity crisis of 2000 and 2001 while executives told investors the company was sound (Gibney, 2005).

Practice 1: Mark-to-Market Accounting

In 1992 the Securities and Exchange Commission approved Enron's request to use mark-to-market accounting for its natural gas trading contracts, allowing it to book the estimated value of a long-term contract as income when the contract was signed. The film shows how the method spread to deals with no market price, such as a planned video-on-demand venture with Blockbuster, where Enron booked expected profits that never came. Healy and Palepu (2003) explain that because the values rested on management's own forecasts, the method gave executives wide latitude to report whatever earnings the market expected.

Legally, the method was approved. Ethically, it was used to tell investors something false: that profits had been earned when they had only been imagined. The purpose of financial reporting is to inform, and a method used to mislead fails that purpose even when it is permitted.

Practice 2: Special Purpose Entities

Enron created partnerships, many run by its chief financial officer, Andrew Fastow, to move debt and poorly performing assets off its balance sheet. Accounting rules at the time allowed an entity to stay off the books if an outside investor held at least 3 percent of its equity. Arthur Andersen, Enron's auditor, approved the structures. Healy and Palepu (2003) show that several did not genuinely meet the rules, and that even those that did were designed to hide risk, since Enron itself stood behind them with its own stock.

Here the line between legal and illegal blurred, and the fact that it was hard to see was the point. The structures were built to satisfy the technical test while defeating its purpose, which was to reveal who bore the risk. The CFO's conflict of interest, running partnerships that traded with his own employer, was approved by Enron's board, which suspended its own ethics code to allow it. A board waiving its code for a single deal is a clear sign that compliance had replaced conscience.

Practice 3: The California Electricity Crisis

The film plays recordings of Enron traders laughing about price spikes and planned outages in California in 2000 and 2001, when the state's partly deregulated market let traders profit from shortages. Some strategies exploited loopholes in market rules; others were later found to be manipulation. Traders defended themselves by saying they were doing what the market rules allowed.

Even where a strategy was within the rules, causing or exploiting blackouts that endangered people for profit fails any ethical test. A utilitarian test fails because the harm to millions outweighed the gain. A duty-based test fails because it treated the public as means only. And the virtue test fails in the recordings themselves.

Why the Gap Opened

Three conditions let Enron's managers treat legality as morality. Incentives rewarded reported earnings, so the system paid for aggressive accounting. A culture that ranked and fired the bottom performers each year taught employees that results mattered more than means. And the gatekeepers who should have objected, the auditor, the board and analysts, each had reasons to approve. Each of these turned "Is it allowed?" into the only question.

Lessons for Managers

Compliance is a floor, not a standard. A manager should ask of any approved practice whether it serves the purpose of the rule it satisfies, whether the people affected would accept it if they understood it and whether it would survive public explanation. Enron's practices failed all three tests long before any court ruled on them.

References

Byars, S. M., & Stanberry, K. (2018). Business ethics. OpenStax.

Gibney, A. (Director). (2005). Enron: The smartest guys in the room [Film]. Jigsaw Productions.

Healy, P. M., & Palepu, K. G. (2003). The fall of Enron. Journal of Economic Perspectives, 17(2), 3-26. https://doi.org/10.1257/089533003765888403