Ethics in contemporary business

Famous business magazine Fortune named Enron "America's Most Innovative Company" six years in a row prior to its collapse in 2001. The rise of this company was simply spectacular, could easily beat the imagination of even the fiction writers. After being formed in 1985 by a merger between Houston Natural Gas Co and InterNorth Inc, in just 15 years, Enron grew from nowhere to America's seventh largest company, employing 21,000 staff members in more than 40 countries. Its share price skyrocketed to an all time high of $90.56 in the year 2000. To the surprise of everyone the success story took an about-turn within just a few days.

The fall of this mighty corporation was even more dramatic. In August 2001, the company's broadband division reported an unprecedented huge loss of $137 million. Consequently the share price fell down to $39.95. That was just the beginning of a massive collapse. On October 16, 2001 Enron reported a $618 million loss and a massive $1.2 billion write-off leading its share price to drop further to $33.84. Within just two months, on December 02, 2001 Enron declared chapter 11 - bankruptcy.

It was a clear case of frauds riding on accounting manipulation. Several investigations conducted afterwards revealed that, along with a few directors top executives of the company cooked the books. Enorn's profit was overstated by $600 million and the stockholder equity by $1.1 billion. Those unscrupulous senior most executives and directors pocketed millions of dollars by selling the stocks when the share price was at the peak. One would naturally wonder how the company was able to deceive the regulators with the fabricated financial statements for so many years.

In 1992, the then president of Enron's trading operations was able to convince the federal regulators to apply an accounting method known as "mark to market". This technique allows businesses to record the price or the value of a security on a daily basis. Earlier, only brokerage and trading companies were following this accounting principle. To explain it further, all the projected earnings from the long-term contracts were being recorded as current income in Enron's books. Revenue was inflated by manipulating projections of future income. This inflated revenue on the books helped to raise the stock price.

Enron used "special purpose entities" (SPEs) to access capital or hedge risk and thereby hiding huge amount of debts and useless assets. SPE, which is basically a limited partnership with outside parties, allows a company to increase leverage and ROA (return on assets) without having to report debt on its balance sheet. The company contributes hard assets and related debt to an SPE in exchange for an interest. The SPE then borrows large sums of money from a financial institution to purchase assets or conduct other business without the debt or assets showing up on the company's financial statements. The parent company can also sell leveraged assets to the SPE and book a profit.

There are quite a few instances of many reputed companies manipulating their books to fool the stakeholders but eventually collapsed and had to pay dreadfully. No sooner the Enron scam was over, another billion dollar scandal of telecom giant WorldCom shook the entire business world heavily. Over the years, this company was reporting operating expenses as investments. It was reported that, a total of $3.8 billion worth of operating expenses were booked as investments over a period of time and thereby exaggerating the profits. In fact, the list of such accounting scandals is not small.

All these scandals eventually prompted the regulators to come up with new regulations and laws to ensure authenticity and accuracy of financial reporting for the publicly held business entities. The then US president George Bush signed the famous law in 2002 popularly known as the Sarbanes-Oxley Act. This act also known as SOX was drafted by US Congressmen Paul Sarbanes and Michael Oxley. Fundamental objectives of this act were to improve corporate governance and accountability. All the US public companies -- domestic and foreign -- that trade securities on a US exchange are subjected to the SOX Act.

This act covers a lot with regards to corporate governance. The major and critical areas covered by SOX act are: internal control; the role of the audit committee, CFO and CEO; management responsibilities; disclosure and reporting procedures and timelines, as well as corporate criminal fraud and accountability.

Internal control is a key element of SOX act. There are broadly five fundamental areas of internal control:

1. Control environment: refers to the policies and procedures that reflect the overall attitude of the top executives, board of directors, and owners of an entity about internal control and its importance. Some of the key aspects of the control environment are:

Defined code of conduct to drive integrity and ethical values

Assignment of authority and responsibility by providing clear job descriptions

Role of board of directors and audit committee. Audit committee should comprise of all independent directors who are financially literate

Organisational structure - how business functions

Human resources policies and practices related to recruitment, promotion, compensation, training and development.

2. Risk assessment:  The aim is to minimise errors and frauds. Key activities involved here are:

Identifying the factors that may increase risk

Determining the significance of risk and likelihood of occurrence

Developing specific actions to reduce risk to an acceptable level

3. Monitoring and Reviewing: The system of internal control should be periodically reviewed by management. This can be ensured by:

An internal audit department

To maintain internal audit independence, it is imperative that they be independent of operating and accounting departments; and that they report to a high level of authority, preferably the audit committee of the board of directors

4. Information and communication: The availability of information and a clear and evident plan for communicating responsibilities and expectations is paramount to a good internal control system.

5. Control activities: These are the activities that occur within an internal control system. Some of these activities include:

Adequate segregation of duties

Proper authorisation of transactions and activities

Adequate documents and records

Physical control over assets and records

Independent checks on performance

History shows even tighter regulatory environment could not stop businesses to manipulate their books. Recent large scale accounting scandals of American Insurance Group (AIG) or Lehman Brothers prompted the million dollar question again - how to stop such ruinous frauds?

While laws and tighter internal control framework are important, perhaps the most important tool to prevent unethical ways of doing business is the ethical values being practised all across the society at large. At the end of the day individual's integrity matters the most.

The writer is managing director of Syngenta Bangladesh Ltd.