AUDIT AND ASSURANCE

Instructor:
Ma’am Ayesha Munir
Submitted by:
Areez Israr
(L1F19BSAF0066)
Enron Scandal:
Enron was formed by Kenneth Lay, in 1895 by merger of Houston Natural Gas Company and
Omaha-based InterNorth Incorporated. It was an American energy, commodities and services-
based company based in Houston, Texas. The company was initially named “HMG/InterNorth
Inc.” in 1986 Lay was appointed as the Chairman and CEO of the company. They firstly
distribute natural gas in a regulated way. Overtime, the firm’s business focus shifted from the
regulated transportation of natural gas to unregulated energy trading markets.

In 1990, Lay created Enron Finance Corporation and Jeffrey Skilling, who was an energy
consultant, was hired to run it. He was a big person behind this scandal. In 1992, company
diversified in many sectors, they set up natural gas pipelines, they started electricity plant, they
entered in broadband service and they also started paper & pulp plants. But these are not
company’s main businesses. In February 12, 2001, Skilling becomes CEO while Lay stays on as
chairman. After that Fortune magazine named this company as No. 1 company. At Enron’s peak,
its shares were worth $90.75 just prior to declaring bankruptcy on December 2, 2001, share price
fallen to $0.26.

One of Skilling’s early contribution was to change Enron’s accounting method from traditional
historical cost accounting method to mark-to-market (MTM) accounting method, and company
received the official approval from SEC in 1992. MTM is the measure of fair value of accounts
that can change over time, such as assets and liabilities. It aims to provide a realistic appraisal of
an institution’s or company’s current financial situation. Some believe it was the beginning of
the end of Enron as it permitted the organization to log estimated profits as actual profits.

In October 1999, Enron created an electronic trading website that focused on commodities,
website’s name was Enron Online (EOL). Enron was the counterparty to every transaction on
EOL; it was either the buyer or seller. One of the many unwitting players in the Enron scandal
was Blockbuster. In mid of 2000, EOL was executing nearly $350 billion in trades. By the fall of
2000, Enron was starting to crumble under its own weight. CEO Jeffrey Skilling hid the financial
losses of the trading business and other operations of the company using mark-to-market
accounting. This technique measures the value of security based on fair value instead of book
value.
In Enron’s case, the company built an asset, such as a powerplant, and immediately claim the
projected profits on its books. If the revenue form that asset is less than the projected amount,
company transferred that asset to the off-the-books corporation where the loss would go
unreported. Mark-to-market practice led to schemes that were designed to hide the losses and
make the company appear more profitable than it really was. In 1998, Andrew Fastow was
promoted to chief financial officer and he planned to show that company is in sound financial
shape despite the fact that many of its subsidiaries were losing money.

Fastow and others at Enron arranged a scheme to use off-balance-sheet special purpose vehicles
(SPVs). These are also known as special purpose entities (SPEs) and they hide their mountains of
debts and toxic assets from investors and creditors. The aim of SPVs was to hide accounting
realities and these were not illegal. Enron believed that their stock price would continue to rise.
Eventually, Enron’s stocks declined. Value of SPVs also fell which forces Enron’s guarantees to
take effect.

Enron’s accounting firm Arthur Andersen LLP and partner David B played a major role in
Enron’s scandal. However, despite Enron’s poor accounting practices, Arthur Andersen offered
its stamp of approval, signing off on the corporate reports for years. In April 2001, many analysts
started to question Enron’s earnings and the company’s transparency. In summer 2001, Enron
was in freefall. CEO Kenneth Lay has retired in February, Jeffrey Skilling becomes the new
CEO. In August 2001, Skilling resigned as CEO due to personal reasons. Around the same time,
analysts began to downgrade their rating for Enron’s stock, and the stock was reduced to $39.95.
in October 16, the company reported its first quarterly loss and closed its SPV. Enron’s this
action caught the attention of SEC.

Shortly after, the SEC announced it was investigating Enron and SPVs created by Fastow.
Fastow was fired from the company on that day. Enron had losses of $591 million and had $690
million in debt by the end of 2000. In December 2, 2001, Enron had filed for bankruptcy.

Enron’s scandal led to new regulations and legislation to promote the accuracy of financial
reporting for publicly held companies. In July 2002, President George W. Bush signed into law
the Sarbanes-Oxley Act. The act heightened the consequences for destroying, altering, or
fabricating financial statements and trying to defraud shareholders.
WorldCom Scandal:
The WorldCom scandal was a major accounting scandal that came to light in the summer of
2002. It was a second largest long distance telephone company at that time. WorldCom provide
phone services which are landlines and mobiles. They rented the phone towers and phone lines
and they charge the customers for services. During the years 1994-1999, the business was really
good. They were making revenues & profits.

From 1999 to 2002, senior executives at WorldCom led by founder and CEO Bernard Ebbers,
planned a scheme to inflate earnings in order to maintain WorldCom’s stock price. It was
uncovered in June 2002, when vice president Cynthia Cooper started to lead company’s internal
audit unit, discovered over $3.8 billion of fraudulent balance sheet entries. In December 2000,
Kim Emigh who was the financial analyst of WorldCom, was told to allocate labor for capital
projects in WorldCom’s network systems division as an expense rather than book it as a capital
project. By Emigh’s estimate, the order would have affected capital expenditures by at least $35
million.

Chief financial officer Scott Sullivan, called Cooper who was the boss of internal audit
department of WorldCom, for a meeting about audit projects, and asked the internal audit team
to walk him through recently completed audits. Cooper asked about the prepaid capacity entries.
Sullivan claimed that these entries are referred to costs related to SONET rings and lines that
were either not being used at all. He claimed that those costs were being capitalized because the
costs associated with the line leases were fixed even as revenue dropped.

He planned to take a restructuring charge in the second quarter of 2002, and asked Cooper to
postpone the capital-expenditure audit until the third quarter, which becomes suspicious for
Cooper.

Cooper and Smith called Max Bobbitt, who was the board member and chairman of the Audit
Committee of WorldCom, to discuss their concerns. He was concerned enough to tell Cooper to
discuss the matter with Farrell Malone of KPMG, who was the external auditor of WorldCom.
KPMG had inherited the WorldCom account when it bought Arthur Andersen’s Jackson practice
in the wake of Andersen’s indictment for its role in the accounting scandal at Enron. By this
time, the internal audit team had found 28 prepaid capacity entries dating back to the second
quarter of 2001. By their calculations, WorldCom’s profit $130 million in the first quarter of
2002 would have become a $395 million loss.

Cooper didn’t wait and decided to ask the accountants who made those entries to provide proves
for them. Before it, Kenny Avery was asked by Cooper, who had been Andersen’s lead partner
on the WorldCom account before KPMG took over, if he knew anything about prepaid capacity.
Avery replied that he had never heard of this term and told that he knew nothing in Generally
Accepted Accounting Principles (GAAP) that allowed for capitalizing line costs and he had
never tested WorldCom’s capital expenditures.

Betty Vinson was the accounting director who made the entries without knowing what they were
for or seeing support for them. She had done so at the direction of Myers and general accounting
director Buford Yates. Myers was questioned by internal auditors and he admitted that there was
no supporting of the entries. Bobbitt finally called an Audit Committee meeting for June 20. By
this time, Cooper’s team had discovered over $3 billion in questionable transfers from line cost
expense accounts to assets from 2001 to 2002.

Sullivan claimed that WorldCom had invested in expanding the telecom network from 1999
onward, but the expected expansion in customer usage never occurred. He argued that the entries
were made on the basis of matching principle, which allowed costs to be booked as expenses so
they align with any future benefit accrued from an asset.

Over the weekend, Cooper and her team discovered several more suspicious “prepaid capacity”
entries. The internal audit unit had discovered a total of 49 prepaid capacity entries of $3.8
billion in transfers spread out across all of 2001 and the first quarter of 2002. Several of entries
were made at the directions from Sullivan and Myers. While some of the entries were made by
managers and directors, others were made by lower-level accountants who didn’t know the
seriousness of what they were doing.

KPMG had discovered that Sullivan had moved system costs across a number of property
accounts, allowing them to be booked as capital expenditures. And also, Andersen’s accountants
had never approved the entries. Sullivan could not persuade the Audit Committee and KPMG by
his explanation. They concluded that the amounts were transferred with the sole purpose of
meeting Wall Street targets, and restating corporate earnings for all of 2001 and the first quarter
of 2002 was the only acceptable remedy. WorldCom publicly admitted that it had overstated its
cash flow by over $3.8 billion over the previous five quarters. Even before the scandal broke, its
credit had been reduced to junk status, and its stock had lost over 94% of its value.

The Sarbanes-Oxley Act is said to be passed due to scandals such as WorldCom and Enron,
which will strengthen the disclosure requirements and penalties for fraudulent accounting.