GROUP ASSIGNMENT: Audit Case of Enron Corporation and Andersen, LLP (Case 4!"
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Case 4! ENRON CORPORATION AN; AN;ERSEN, LLP Ana'$?in& t*e @a'' of T
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Enron's origins date back to 1985 when it began life as an interstate pipeline company through the merger of Houston Natural Gas and maha!based "nter North# $enneth %ay& the former chief eecuti(e officer of Houston Natural Gas& became )E& and the net year won the post of chairman# *rom the pipeline sector& Enron began mo(ing into new fields# "n 1999& the company launched its broadband ser(ices unit and Enron nline& the company's website for trading commodities& which soon became the largest business site in the world# +bout 9, per cent of its income e(entually came from trades o(er Enron nline# Growth for Enron was rapid# "n -,,,& the company's annual re(enue reached.1,, billion /0# "t ranked as the se(enth!largest company on the *ortune 5,, and the sith!largest energy company in the world# he company's stock price peaked at .9, /0# Howe(er& cracks began to appear in -,,1# "n +ugust of that year& 2effrey 0killing& a dri(ing force in Enron's re(amp and the company's )E of si months& announced his departure& and %ay resumed the post of )E# "n ctober -,,1& Enron reported a loss of .318 million4 its first uarterly loss in four years# )hief financial officer +ndrew *astow was replaced& and the /#0# 0ecurities and Echange commission launched an in(estigation into in(estment partnerships led by *astow# hat in(estigation would later show that a comple web of partnerships was designed to hide Enron's debt# Enron reported annual re(enues of about .1,1 billion between 1985 and -,,,# n 6ecember 18& -,,,& Enron's stock sold for .87#8 per share# 0tock prices fell throughout -,,1& and on ctober 13& -,,1& the company reported losses of .38 million in the third uarter alone# 6uring the net si weeks& company stock continued to fall& and by 6ecember -& -,,1& Enron stock dropped to below .1 per share after the largest single day trading (olume for any stock listed on either the New :ork 0tock Echange or the N+06+;# n 6ec# -& -,,1& Enron filed for bankruptcy protection in the biggest case of bankruptcy in the /nited 0tates up to that point# 5&3,, Enron employees subseuently lost their ig *i(e= accounting firms in the /nited 0tates& and it had ser(ed as Enron's auditor for 13 years# +ccording to court documents& Enron and +rthur +ndersen had improperly categori?ed hundreds of millions of dollars as increases in shareholder euity& thereby misrepresenting the true (alue of the corporation# +rthur +ndersen also did not follow
generally accepted accounting principles @G++AB when it considered Enron's dealings with related partnerships# hese dealings helped Enron to conceal some of its losses# +rthur +ndersen was also accused of destroying thousands of Enron documents that included not only physical documents but also computer files and E!Cail files# +fter in(estigation by the /0 2ustice 6epartment& the firm was indicted on obstruction of
1# /nderstand the e(ents leading to EnronDs bankruptcy and +ndersenDs downfall *actors that )ontributed to EnronDs bankruptcy )orporate culture and reward system# ;uality of o(ersight pro(ided by board of directors# Femuneration pro(ided to board of directors# Carket ideology of top management# Nature of contract with auditors& +rthur +ndersen# +pproach taken by corporate lawyers# %obbying of regulators# Felationship with elected officials# Ethics of top corporate officials# Canaging the stock price& to the eclusion of all else# %ying to shareholders and the in(estment community# Canipulating re(enue by mark to market accounting# Candating that pensions be held in Enron stock#
*actors that )ontributed to +ndersenDs downfall he failure to acknowledge the conflict of interest in pro(iding consulting ser(ices to the same companies& they were auditing# he auditors saw the conflict and knew it was wrong# /nfortunately& the profits outweighed the ethical standards of the company# + second concern of unethical practices was brought to the attention of the leadership team regarding conflict of interest& which was brought up by an auditor# Father than rectifying the situation& they a(oided it# he team disregarded the notion of conflict of interest and remo(ed the auditor as well as any hard copies suggesting that there was a conflict of interest# *urthermore& their actions sub
-# +ppreciate the importance of understanding an audit clientDs core business strategies +s stated in "0+ 1,& auditors are reuired to obtain a reasonable understanding of the clienDs business and industry# he nature of the clientDs business and industry affects client business risk and the risk of material misstatement in the financial statements# +uditors use the knowledge of these risks to determine the appropriate amount of audit e(idence to gather# +uditors ha(e been eposed to problems resulting from the auditorDs failure to understand comprehensi(ely the nature of transactions in clientDs industry# # Fecogni?e potential conflicts arising from auditor relationships with their clients +ccountants in public practice should be independent in fact and appearance when pro(iding auditing and other attestation ser(ices# "f auditor pro(ide attestation or assurance ser(ices to clients& a conflict of interest will pre(ent auditor from also pro(iding in(estment ad(isory ser(ices#
0pecifically& conflict of interest situations include General reuirements& including the pro(ision of certain non!audit ser(ices& and 0pecific relationships of the auditor andor audit team members with the audited entity&
*urthermore& +")A+ rules state that an accountantDs independence will be impaired if the accountant Cakes in(estment decisions on behalf of audit clients or otherwise has discretionary authority o(er an audit clientDs in(estments# Eecutes a transaction to buy or sell an audit clientDs in(estment# Has custody of assets of the audit client& such as taking temporary possession of securities purchased by the audit client#
7# /nderstand how accounting standards may ha(e contributed to the Enron debacle and describe how the accounting profession is seeking to change the fundamental nature of those standards Arior to the fall of Enron and their accountants& +rthur +ndersen& there were many different types of safety measures in place to help protect the in(estors and the public as a whole# hese safety measures included Generally +ccepted +ccounting Arinciples @G++AB& Generally +ccepted +uditing 0tandards @G++0B& 0tatements on +uditing 0tandards @0+0B& and all professional ethics# he use of G++A by accountants is standard protocol# +n accountant follows these principles as a matter of daily routine# +ccording to 0e(eral accounting tets& G++A is identified as a dynamic set of both broad and specific guidelines that companies should follow when measuring and reporting the information in their financial statements#I
6uring yearly audits performed by eternal& independent auditors& checks are performed to make sure that a business is following G++A consistently# "f they are not& then the business must show why they are not& and present rationale to demonstrate that what they are doing is both ethical and appropriate in their specific situation# his lea(es the field open to interpretations of what is appropriate for different situations# 0ince interpretations are uite sub
+ll in all& eecuti(es at +rthur +ndersen and Enron did not set out to ha(e a positi(e impact on the accounting industry or any industry# hey set out to make as much money for themsel(es as uickly as possible# hey were willing to do whate(er it took to make that money# hese thoughtless acts and greed led both companies to an e(entual downfall in bankruptcy# Howe(er& the accounting industry reacted by introducing changes that would& in the long run& impro(e itself and the economy in which it eists# he changes that are a response to the +ndersenEnron debacle may be coming to an end# Je are probably seeing the last laws& pronouncements& and statements that are a direct result of these actions# 0till& the changes that ha(e occurred lea(e the accounting industry and the economy stronger# 5# )onsider challenges facing the accounting profession and e(aluate alternati(e courses of action for o(ercoming these obstacles +n accountant working in the public or pri(ate sector must remain impartial and loyal to ethical guidelines when re(iewing a company or indi(idual's financial records for reporting purposes# +n accountant freuently encounters ethical issues regardless of the industry and must remain continually (igilant to reduce the chances of outside forces manipulating financial records& which could lead to both ethical and criminal (iolations#
0ome of these ethical issues include Aressure *rom Canagement he burden for public companies to succeed at high le(els may place undue stress and pressure on accountants creating balance sheets and financial statements# he ethical issue for these accountants becomes maintaining true reporting of company assets& liabilities and profits without gi(ing in to the pressure placed on them by management or corporate officers# +ccountant as Jhistle!blower +n accountant may face the ethical dilemma of reporting disco(ered accounting (iolations to the *inancial +ccounting 0tandards >oard# Jhile it is an ethical accountant's duty to report such (iolations& the dilemma arises in the ramifications of the reporting# he Effects of Greed Greed in the business and finance world leads to sha(ing ethical boundaries and stepping around safeguards in the name of making more money# +n accountant can ne(er let the desire to earn a better li(ing and acuire more possessions get in the way of ensuring that she follows ethical guidelines for financial reporting mission of *inancial Fecords + corporate officer or other eecuti(e may ask an accountant to omit or lea(e out certain financial figures from a balance sheet that may paint the business in a bad light to the public and in(estors# mission may not seem like a significant breach of accounting ethics to an accountant because it does not in(ol(e direct manipulation of numbers or records#
+ll in all& all of these are precisely why an accountant must remain ethically (igilant to a(oid falling into such ethical dilemma and always be competent& independent& and professional# Reuired
1# Jhat were the business risks Enron faced& and how did those risks increase the likelihood of material misstatements in EnronDs financial statementsK he business risks that Enron faced included foreign currency risks and price instability& which is common for the energy industry# "n addition& Enron faced pressure to perform well so that the stock price would rise# hese risks increased the likelihood of material misstatements in the financial statements for se(eral reasons# 0ince Enron operated in other countries& there would be a foreign currency risks and those could lead to gainslosses not being properly calculated or accrued on hedging acti(ities# >y operating in foreign countries& there are political risks such as policy changes& lack of understanding of culture and business practices# he biggest risk is ha(ing the pressure to report good financial results# he deals with the special purpose entities @0AEDsIB depended on a high stock price# he company used its stock as collateral if the stock price fell below a certain price# +t that point& Enron would ha(e to use the stock to pay out the in(estors# he company also had pressure from its business partners to perform well and meet its future obligations# "f the company performed poorly& the in(estors may hesitate to do business with Enron# -# Jhat are the responsibilities of a companyDs board of directorsK )ould the board of directors at Enron4especially the audit committee4ha(e pre(ented the fall of EnronK 0hould they ha(e known about the risks and apparent lack of independence with 0AEDsK Jhat should they ha(e done about itK a# Jhat are the responsibilities of a companyDs board of directors he board of directors is appointed to act on behalf of the shareholders to run the day to day affairs of the business# he board are directly accountable to the shareholders and each year the company will hold an annual general meeting at which the directors must pro(ide a report to shareholders on the performance of the company#
b# )ould the board of directors at Enron4especially the audit committee4ha(e pre(ented the fall of EnronK "t is impossible to know whether >6 of Enron can pre(ent the fall of this company since thereDs fraud opportunity in this company& that can be seen through
*ormer )hief +udit Eecuti(e Enron @Head of internal auditB originally is +ndersen's partner who is appointed as a public accountant of the company#
Enron's finance director comes from +ndersen#
Cost of Enron's accounting staff came from +ndersen#
>ut thereDs something that can be done to pre(ent fraud
Establish or adopt audit standards& control uality& ethics& independence and other standards relating to audits of public companies "n(estigate $+A and its employees& conduct disciplinary hearings& and impose sanctions if necessary )arry out other obligations reuired to impro(e professional standards in the *irm
c# 0hould they ha(e known about the risks and apparent lack of independence with 0AEDsK Jhat should they ha(e done about itK "n the late 199,Ds the company was eperiencing unprecedented growth and le(eraged high stock prices in order to enter into a number of transactions known as special purpose entitiesI @0AEDsB# Jith these transactions& Enron recei(ed borrowed loans that appeared as re(enue& without any liability on the balance sheet& and were guaranteed by Enron stock# he companyDs board of directors is supposed to act as shareholder representation and assist with policies and issues# he board of directors could ha(e taken a further look into the transactions that were occurring to pre(ent the fall of Enron# hey should ha(e known about the issues with the 0AEDs& especially the amount of transactions including them& and put an end to continued transactions and make the necessary corrections for the financial reporting# # "n your own words& summari?e how Enron used 0AEDs to hide large amounts of company debt# Enron created 0AEDs @usually other %%ADsB in order to create cash inflow but did not record the in(estments and related liabilities @the loans used to create the 0AEB# Enron used outside in(estors to secure the new 0AEDs# he new in(estors would bear the risk of the in(estment and Enron used its company stock as collateral to entice the in(estors and saying that Enron would basically bear the risk if the in(estment should turn sour# Enron used large in(estment bankers to take loans but these looked more like hedging acti(ities instead of debt# nce the stock price began to drop& and Enron was losing money& they were unable to use their stock to co(er the losses# o put it simply& a company sells a product for a stellar price to another entity# Howe(er& that entity doesnDt ha(e the cash
flow to buy the product# 0o& the seller issues a loan to the buyer in order to sell the product# Now if the buyer defaults on the loan& the seller loses the cash it lent out and the product it sold# his is how Enron set up the 0AEDs& and they used the large in(estment banks to hold the loans that should ha(e been reported on EnronDs balance sheet 7# Jhat are the auditor independence issues surrounding the pro(ision of eternal auditing ser(ices& internal auditing ser(ices& and management consulting ser(ices for the same clientK 6e(elop arguments for why auditors should be allowed to perform these ser(ices for the same client# 6e(elop separate arguments for why auditors should not be allowed to perform non!audit ser(ices for their audit clients# Issue: Jhether or not the auditors can be independent and eercise good professional
Howe(er& we strongly agree with the statement that auditors should not perform non!audit ser(ices to their clients# +ccording 0arbanes!ley!+ct& title "" consists of nine sections and establishes standards for eternal auditor independence& to limit conflicts of interest# "t also addresses new auditor appro(al reuirements& audit partner rotation& and auditor reporting reuirements# "t restricts auditing companies from pro(iding non!audit ser(ices @consultingB for the same clients# "t is against the act if any auditor fails to obey these rules# "t will be assumed that the auditor lack of independence in issuing the audit report if pro(ide non!audit ser(ices for the same client# 5# Eplain how rules!basedI accounting standards differ from principles!basedI standards# How might fundamentally changing accounting standards from bright!lineI rules to principle!based standards help pre(ent another Enron!like fiasco in the futureK +re there dangers in remo(ing bright!lineI rulesK Jhat difficulties might be associated with such a changeK Fule based accounting standards are difference from principle!based standards in that rule!based standards are
uestionable practices& e(en if they are following the letter of the law# "f bright lineI rules are not relied on at all& and only principle!based rules are followed& then the interpretation of these principles can cause issues such as aggressi(e accounting treatments such as in the Enron case# "f there are no hard rules& then companies can say that the aggressi(e accounting treatments are not prohibited# 3# Enron and +ndersen suffered se(ere conseuences because of their percei(ed lack of integrity and damaged reputations# "n fact& some people belie(e the fall of Enron occurred because of a run on the bank#I 0ome argue that +ndersen eperienced a similar run on the bankI as many top clients uickly fired the firm in the wake of EnronDs collapse# "s the run on the bankI analogy (alid for both firmsK Jhy or why notK +ccording to the business dictionary& a run on the bank is when indi(iduals withdraw funds out of fear that it will become insol(ent in the near future# Jhen 0killing blames EnronDs collapse on a classic run on the bankI& at first glance it seems that this definition fits what happened at Enron# Howe(er& 0killing goes on to say that when e(eryone started to back away from Enron& Enron was sol(ent and highly profitable& easly& >uckless& Glo(er& M Arawitt& -,1-B# his was not the case though# George $aufman& an economist at %oyola /ni(ersity )hicago eplains he fable is that a run can bring down a sol(ent bank# Jhat a run does is "t causes an insol(ent bank to be recogni?ed as insol(entI @Ceyerson& -,,3& para# 1,B# his is important because& while the withdrawals might ha(e epedited the collapse& it was not the actual cause& as Enron was on its way out already# he fact that %ay sold o(er 9&,,, shares and that )itigroup& 2ACorgan )hase& and 6ynegy did not go through with helpingI Enron& shows that they knew Enron was& indeed& insol(ent# "n the case of +ndersen& this analogy does not work since clients started to drop the firm because they either felt that the firm was in(ol(ed in fraudulent acti(ities& or that the mere appearance would damage their own reputation if they stayed with +ndersen# No fear of insol(ency had any part they
not directly in(ol(ed or knowledgeable of the situation& some may gain the perception that we are in(ol(ed and it could lead to our termination and loss of ability to obtain new employment# Jhen people start to uestion your integrity& this can cause a snowball affect where other people begin to do so as well and they no longer trust your work or terminate your employment# "n order to a(oid these situations& always present yourself honestly and a(oid situations that may be uestionable# he backup of facts or written documentation can help you to a(oid this and knowing when to in(ol(e higher le(els or a third party when you disco(er illegal or unethical beha(ior is crucial to maintaining integrity 8# Jhy do audit partners struggle with making tough accounting decisions that may be contrary to their clientDs position on the issueK Jhat changes should the profession make to eliminate these obstaclesK %ike any other business accounting firms want to make money# *or that purpose& public accounting firms are concern with making clients happy& pro(iding them with the outstanding customer ser(ice# his is the reason why auditors struggle with making tough accounting decisions that may be contrary to their clientDs position# +uditors donDt want to upset clients and risk losing money# o keep a good relationship& auditors may not oppose to the clientDs accounting choices& e(en if it is not following the accounting standards# + change the profession could make to eliminate these obstacles is to first be dedicated to the public interest# "f the auditor suspects foul play in the financial statements& it should be reported to management right away# his will help eliminate difficult decisions& if similar situations occur again& because a guide base is set# 9# Jhat has been done& and what more can be done to restore the public trust in the auditing profession and in the nationDs financial reporting systemK +fter the accounting scandal of Enron and +ndersen& )ongress passed the 0arbanes!ley bill& to protect in(estors by impro(ing the accuracy and reliability of corporate disclosures and changing the way corporate boards deal with their financial auditorsI @Aea(ler& 0eptember -,13B# he Aublic )ompany +ccounting (ersight >oard& A)+> was created to o(ersee audits of public companies and broker!dealers& while protecting in(estors and the public interest# he A)+> promotes informati(e& accurate& and independent audit reports @+bout the A)+>& -,13B# o restore& the public trust in auditing profession and in the nationDs financial system& auditors and companies should display their dedication to disclosing accurate financial statement#