Enterprise Risk Management (Preview)

Chapter 1 – Risk Management Awareness 17 Securities commissions such as the Securities and Exchange Commission (SEC) in the United States, and the Canadian Securities Association developed regulations that support Sarbanes-Oxley and Dodd-Frank. In addition, stock exchanges such as the New York Stock Exchange (NYSE) and the Toronto Stock Exchange (TSX) established rules that complement these laws and regulations. Because many international companies are publicly traded in the United States, the laws, regulations and rules adopted in the United States greatly influence those of other countries. They also create stakeholder expectations that better risk management practices should be implemented across all types of organizations, including government entities and not-for-profit organizations. Credit rating agencies such as Standard & Poor’s, Moody’s Investors Service and Fitch Ratings examine the risk management practices of organizations. These agencies assess the overall creditworthiness of organizations, and the credit risk of each of their negotiable debt obligations. They use pre-defined criteria to conduct their assessment of risk management practices. The criteria help organizations understand what is required to improve risk management in order to achieve better credit ratings and secure more favorable credit terms. Organizations have a clear interest in obtaining good credit ratings, and sound risk management practices are an important factor. Accounting Scandals of 2001-02 The failure of the Enron Corporation, and the related collapse of Arthur Andersen, the accounting firm that conducted the financial statement audits of Enron, were catalysts that led to the Sarbanes-Oxley Act of 2002. Based in Texas, Enron was involved in the trading of energy contracts and derivatives. Some of these transactions were done using “special purpose entities.” These entities were created to purchase assets from Enron, and Enron recorded asset sales and income as a result. However, Enron maintained various types of financial obligations related to the assets that it sold, and these obligations were not recorded as liabilities on its balance sheet. The very large number of special purpose entities (hundreds were created) and the size of the transactions made the business model of Enron rather deceptive. When lenders and trading partners began to lose confidence, loans were called and Enron became insolvent. Enron filed for bankruptcy in December 2001. With total assets exceeding $60 billion 11 at the end of September 2001, Enron became the biggest bankruptcy in the history of the United States at the time. Arthur Andersen was indicted and convicted for obstruction of justice in regard to the destruction of documents related to Enron. However, the conviction was overturned by the United States Supreme Court on the basis that the trial judge had not properly instructed the jury. Nonetheless, by the time that court deliberations were over, the reputation of Arthur Andersen was irreparably damaged and the firm ceased operations. The bankruptcy of WorldComwas another major event that led to Sarbanes-Oxley. During the 1990’s WorldCom evolved as a fast growing telecommunications company based in Mississippi. In the early 2000’s, the company faced tremendous earnings pressure when telecommunication services became much more competitive. WorldComwas found guilty of accounting fraud, namely the capitalization of network lease payments to its balance sheet, when such payments should have been expensed when incurred. The pretext to capitalize lease payments was that greater network capacity had to be secured than what was actually needed in order to attract new customers. Such an accounting treatment was