The Collapse of Enron Seemed to Be a Thumb in the Nose to the Efficient Markets Hypothesis and Agency Theory. Discuss.

Topics: Enron, Enron scandal, Stock market Pages: 6 (2232 words) Published: October 13, 2008
The collapse of Enron was entirely related to the accounting practices adopted by the company. It is a number of these questionable, and in some cases straight out fraudulent, accounting practices that pertained to the most dramatic collapse of a major company in years. An analysis of some of these accounting practices brings to light the problems with the use of concepts such as mark-to-market accounting and the use of special purpose entity’s (SPE’s). To say that the collapse “seemed to be a thumb in the nose of the efficient market hypothesis (EMH)” is a statement misguided in the understanding of this concept. One can explain this through the fact that a number of the basic principals of the EMH were satisfied during the time of the Enron collapse. Furthermore, the interrelation of agency theory and EMH, suggests that the basic ideals surrounding agency theory also applied to the Enron Case at some point in time, however the continuation of this principal deteriorated as time went on.

Among a number of questionable and fraudulent accounting practices were two key concepts that hid the true value of the firm so it was not “readily apparent to anyone except a forensic accountant” (Sewer, 2002). These concepts were the use of Special purpose entities (SPE’s) and mark-to-market accounting. The reason to choose analysis of these concepts is that neither is fraudulent in itself, however its application in this case caused a review of these principals. Enron’s use of special purpose entities has been one of the most widely discussed accounting issues of recent times. The use of special purpose entities is common amongst almost all, if not all organizations. A key problem with the way Enron had set up its SPE’s was that it had not established “corporate separateness” that is “a corporation separate from its shareholder, directors and officers, even when it is wholly owned by another corporation” (Thompson, 2004). This is evident in the entity known as LJM. This entity was chaired by Andy Fastow, the then CFO of Enron. In the documentary “Enron: The smartest Guys in The Room”, Fastow is seen pitching the idea of LJM to investors, at one point he is seen explaining the advantages of being the chairman of LJM as well as the CFO of Enron, which is then followed by a question “Is there a conflict of interest?” to which he responds, and I quote, “I will always be on the LJM side of the transaction” (Enron: The Smartest Guys in The Room). Fastow has clearly contradicted himself and footage highlights the issue of corporate separateness. The reason for the use of SPE’s is to “partition specific parts, assets and liabilities of a business to achieve various tax, accounting or liability avoiding goals” (Thompson, 2004). The problem with Enron’s SPE’s was the sheer quantity of them, “in its year 200 Annual Report, Enron lists three thousand affiliates and related companies, including SPE’s” (Thompson, 2004). While SPE’s are used because it allows “the return on an asset to be maximised, and risk minimised, by transferring it to and SPE, which must at some point repay the debt which it has incurred to the vendor company” (Deakin, Konzellman, 2004). The issue lies in the fact that US Generally Accepted Accounting Principles “provides that the assets and liabilities of an SPE do not need to appear on the balance sheet of the vendor company which has set it up” (Deakin, Konzellman, 2004) this allowed for Enron to set up multiple companies into which it could hide debt from investors. A former employee states in an interview on the documentary “Enron: the Smartest Guys in the Room” that “ Enron loved these deals because they produce cash but don’t have to show the debt on the balance sheet” (Enron: The Smartest Guys in The Room). This evidence highlights the unethical use of SPE’s that Enron chose to adopt in the preparation of its financial statements.

The other major Accounting flaw evident at Enron was the use of...

References: Serwer, Andy. 2002, ‘Dirty Rotten Numbers: Enron has made us shine a light on the books of America’s public companies. Now, if your company carries even a hint of bad accounting, the stock will be savaged’, Fortune. Vol 145, i4, p74+.
Shleifer, Andrei. 2000, ‘Are Financial Markets Efficient’ Oxford Scholarship Online – Economics and Finance. Pp 1- 5.
Akdere, Mesut and Azevedo, Ross. 2004, ‘Organisational Development, Agency Theory, and efficient Contracts: A Research Agenda’. Pp2-8.
Deakin, Simon and Konzelmann, Suzanne. 2004, ‘Learning From Enron’ Corporate Governance. Vol 12, pp134-142.
Haldeman, Robert G. 2006, ‘Fact, Fiction, and Fair Value Accounting at Enron’ The CPA Journal. Pp1-10.
Thompson, Robert B. 2004, ‘Corporate Governance after Enron’. HeinOnline. Pp99-117.
Godfrey, Jayne. Hodgson, Allan. Holmes, Scott. Tarca, Ann. 2006. ‘Accounting Theory: Sixth edition’. Wiley, Australia.
‘Enron: The Smartest Guys in The room’ 2005, DVD, Dendy Films. USA.
‘Encarta: Online’. Copyright MSN Encarta, 2008, Accessed 15/05/08 from
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