Naimat Ali Taimoor.
FA17-BBA-010. Section D
Ethical issues in finance and their impact on shareholders value.
There are many situations on our daily life where we take actions without considering that our act is ethical or not. Let us take an example of traveling; people do travel as official trip from company rather than traveling personally just to save tax. Is this act ethical or unethical? These are such type of actions where we do not consider our self as ethical or unethical while these acts have a clear impact on shareholders value.
Ethics are basically the difference between the wrong and right. There are different ethical approaches which clarifies the ethics. Utilitarian approach which says that a decision must be in favor of maximum stakeholders. Justice approach which says that decisions must be neutral and impartial. Moral rights approach which says that decision must not be against rights of the party or any individual and last one is Practical approach which says that a manager should make a decision which he/she can announce publically and people will accept that as right. These are some examples of taking decision with respect to ethics.
How do ethics in finance effect the value of shareholders? To understand this we will take the example of The Enron collapse. One of the greatest fall down of a biggest company of that time. By this example we will get to know some unethical practices in finance and how to the damage shareholders equity.
Enron was formed by collaboration of two energy companies in 1985. It was basically Energy Company but in around 1990s it was doing so much activities that it is not even possible to cover them all. From 1996 to 2000 the value of company raised from $13,289M to $100,789M and it was the time when people wanted to invest in it. Where the market price of its shares raised from $10 to $80 per share. It was the time to invest. So people did. Enron appeared on No1 Company to work for from entire world. But what happened in the very next year. The share of company just felled from $80 to $0.50 and company went bankrupted. How and why this did happened that a company has lost all of its money. All the investment of shareholders was wasted. Actually all the value shown above was nothing but just an illusion. There are few thing which they did so cleverly that people at that time couldnt even think off
They showed false financial statements. They had no revenue but in books they show revenue of $100,000,000. All the records shown in their books were fake. They show revenue while actually they had no revenue. It is also called Mark-to-market accounting. They actually did investments on companies like blockbuster video and expected the return of $100M which never came up but was shown in their books as collected revenue. Their contracts all failed which was the reason behind their bankruptcy.
How did they manage their liabilities? They acquired some small companies and transferred their liabilities to those companies. Now Enron was under huge debt but in their books they were not.
How did their share price managed to rise? When actually they faked all the accounts and people were not in knowledge of it. Their shares were circulating all around the market and their market value was consistently rising. Even the major insiders sold their share just a few days before the company got bankrupted.
What about auditor? It is essential for every firm to have an auditor. At that time Enron was hiring one of the most trusted firms for their auditing of books. Arthur Anderson. They were not doing their jobs they were just getting paid from the huge profit that company was making. While after the charge against Enron their auditing company AA just couldnt survive at all.
Discussed above were all pure unethical practices which are example that how maximization of individuals profit can cost bankruptcy to world largest company of the time? but how did these practices affected the shareholders? Simply all those people who bought the share were the owners of the company who just bought the share to maximize their wealth. They were totally unaware of all the drama played by Enron they were just told that company has raised its value and share price. But due to the unethical practices of the company they suffered the huge loss. People who were in management had no investment in the company the were just enjoying the money in form of their income and bonuses. But when company get bankrupted those were the shareholders whos money was looted.
Some unethical practices, such as fraud and faking financial records, not only place the stockholders at tremendous risk, but also will bring the company under investigation by law enforcement agencies. While there is a significant overlap between ethical standards and legal laws, not all unethical behavior is illegal. The practice of providing a “golden parachute” to executives of failing companies gives the parties responsible for a company’s downfall a comfortable escape, while the ordinary shareholder watches the values of his shares decrease.
Corporate leaders who seek larger profits and higher visibility at the expense of ethical standards can deal major damage to stockholder equity. A major example of this unethical behavior comes from Enron. Not only did Enron see rapid revenue growth in the late 1990s, the company won Fortune magazines Americas Most Innovative Company award every year from 1996 to 2001. In its pursuit of more profits and more publicity, the company took higher risks and hid its losses, resulting in one of the biggest corporate collapses in history.
By these studies we can easily elaborate the relationship between ethics and shareholders value. We can see what is the difference between profit maximization and wealth maximization. Now a days because of these unethical activities which damage the share value corporate governance came into being which is working on Principle agent rule (conflicts between managers and shareholders).
There are many other agencies working all around the world to control it. But there is no big eye than the Eye of Allah Almighty as we are the students of finance we might InshaAllah in future involved in such situations where we have to decide the wrong and right. We must see the entire possible outcomes and keep in mind that we are accountable of all our acts in front of Allah Almighty. May He Who helps everyone Helps us to choose the right path.