MZUMBE UNIVERSITY

DAR ES SALAAM BUSINESS SCHOOL

FACULTY OF COMMERCE

PROGRAMME: MSc. ACCOUNTING AND

FINANCE

SUBJECT: ACC 5221: AUDITING AND ASSURANCE

SERVICES
LECTURER: E.S. Malubi & S.R.Mngoya
TITLE: TERM PAPER

NAME: NGODA, G

Qn. Discuss why, in 2002, the corporate governance structures failed in

both Enron and WorldCom and what would have been done by the
auditors in order to prevent the failures.

0
DATE: 3RD JANUARY 2011

Question

Both Enron and WorldCom had corporate governance structure in place

including presence of Board of Directors and audit committees composed
of appropriately qualified persons. For example, Enron had and an
independent Board of Directors of seventeen members, only two of whom
were insiders and the rest were Chief Executive Officers of other
companies, government officials and academicians. The Enron’s audit
committee was composed entirely of independent directors and was
headed by former professor of accounting at Stanford Business School.

Both Enron and WorldCom were being audited by Arthur Andersen, one
of the big five and most respected audit firms in the world.

Required:
Discuss why, in 2002, the corporate governance structures failed in both
Enron and WorldCom and what would have been done by the auditors in
order to prevent the failures.

1
 TABLE OF CONTENTS

1.0 Introduction……………………………………………………………..…….3

2.0 Corporate governance…………………………………………………..…...4

2.1 Corporate Governance in Enron…………………………………..4

2.2 Corporate Governance in WorldCom………………………….….4

3.0 Reason for failure of corporate governance…………………..............4

3.1 Failure of corporate governance at Enron in 2002……………5

3.2 Failure of corporate governance at WorldCom in 2002………7

4.0 Reasons for audit failure………….……………………….…………….…8

5.0 What would have been done by Auditors…………….…………………9

6.0 Conclusion and recommendation...…………………………..

………...10

Bibliography………………………………………………………………………….11

2
1.0 INTRODUCTION

CORPORATE GOVERNANCE

Corporate governance has a great role in transparency and honesty in

financial reporting. Corporate governance then implies relationships
among an organization’s management, the board, the stakeholders, and
other bodies that have indirect involvement with the company. 1 It also
provides a generalized structure from which the organization’s objectives
emerge. However the process whereby directors of a company are
monitored and controlled, involves decision making, accountability and
monitoring is also defined as corporate governance. 2 Two aspects which
are considered to be fundamental to corporate governance are:
Supervision and monitoring of management performance (the enterprise
aspect) and ensuring accountability of management to shareholders and
other stakeholders.

The failures of high-profile Company like Enron and WorldCom raise the
question of regulatory system as well as serious issues about the
effectiveness of the governance of these companies.

Enron

A Brief background

Enron was created in 1985 from the merger of Houston Natural

Gas and Intermonth, a Nebraska gas company. Enron rode,
and evolved with, the deregulation of the United States energy
markets through the late 1980s and 1990s. It progressively
shed its physical assets to focus on trading and the
development of complex derivative products. Over time it
extended its trading activities to create markets for derivative
products, including paper, coal, metals, telecommunications
bandwidth and even weather. It was regarded as the model of a
‘virtual’, new-age company and in 2001 was named ‘The Most
Innovative Company in America. Over its 15 year history as
1
Victor Gaines, the Role of Corporate Governance in the Financial Institution
Industry, http://www.theiia.org/download.cfm?file=28127(accessed on
December 21, 2010)
2
http://mpra.ub.uni-muenchen.de/15989/1/MPRA_paper_15989.pdf
(accessed on December 21, 2010)

3
Enron, its market capitalization grew from US$2 billion to
US$70 billion. 3
WorldCom

A Brief background

WorldCom, based in Mississippi, was a telecommunications company

that emerged from obscurity during the frenzy of corporate activity in
the sector unleashed by deregulation of the US telecommunications
industry. Through a frenetic series of takeovers — 72 over 17 years —
the company emerged as the second largest US long-distance carrier
and developed the world’s largest Internet protocol network. At its peak
it was valued at about US$180 billion. The ‘improprieties’ involved
treating items that should have been expensed as capital items,
inflating the company’s reported earnings and cash flows by at least
US$3.9 billion over the five quarters to the end of March 2002. Had
the items been expensed, WorldCom would have reported losses for that
period rather than the US$2 billion of profits it claimed to have earned.
The timing of the disclosure may have been a coincidence but
WorldCom’s auditor, Andersen, was replaced by KPMG in May 2002. 3

2.0 CORPORATE GOVERNANCE

2.1 Corporate Governance in Enron

In light view the company was operated and managed in governance with
the presence of responsibility of directors, composition of the board and
good internal control

Enron’s Board structure with five oversight subcommittees could have

been characterized 29 as typical amongst major public American
corporations. The Chairman of the Board was Kenneth Lay, and in 2001
Enron had 15 Board Members. Most of the members were then or had
previously served as Chairman or CEO of a major corporation, and only
one of the 15 was an executive of Enron, Jeffrey Skilling, the President
and CEO.
Enron managed their numbers to meet aggressive expectations. They
were less concerned with the economic impact of their transactions as
they were with the financial statement impact. The Board improperly
allowed conflicts of interest with Enron partnerships and then did not
ensure appropriate oversight of those relationships. There was a

3
Stephen Bartholomeusz, After Enron: The new reform,
http://www.austlii.edu.au/au/journals/UNSWLJ/2002/33.txt/cgi.../2002/33.rtf
(December 16, 2010)

4
fundamental lack of communication and direction from the Board as to
who should be reviewing the related-party transactions and the degree of
such review. The Board was also unaware of other conflicts of interests
with other transactions.4

2.2 Corporate Governance in WorldCom

Having the right people in place is critical to good governance at any

company.
The story of WorldCom’s corporate governance system illustrates the
problems of a large company operating without a true independent board
of directors. At issue, was the fact that WorldCom’s nine member board
was composed of corporate insiders; friends of Bernard Ebbers and
executives from the acquired companies.
Most of WorldCom’s outside director’s board did not have direct access or
get involved with the company’s day-to-day business operations. The
outside directors had little or no contact with company employees other
than during presentations at board meetings. Nor were there systems in
place that would have allowed employees to contact the board with
concerns about company finances or operational matters. Company’s
internal audit department or the Audit Committee perceived the
widespread serious weaknesses in the Company’s internal controls over
external financial reporting.5

3.0 REASON FOR FAILURE OF CORPORATE GOVERNANCE

3.1 Failure of corporate governance at Enron in 2002

Conflicts of Interest
One of the major governance issues brought to light by the bankruptcy of
Enron was the blatant conflict of interest involved with having financial
officers of a company both manage and be equity holders of entities that
conducted significant business transactions with Enron. Enron’s Code of
Ethics and Business Affairs explicitly prohibits any transactions that
involve related parties unless the Chairman and CEO determined that
his participation does not adversely affect the best interests of the
Company, a good example is how the Chewco transaction was handled 6
4
Peter Grosvenor Munzig, Enron and the Economics of Corporate Governance,
http://www.economics.stanford.edu/files/Theses/Theses_2003/Munzig.pd (December
14,2010)
5
http://www.cem.ulaval.ca/pdf/gershon_alhassan.pdf (December 17, 2010)
6
Gopinath. C, Corporate governance failure at Enron
http://www.thehindubusinessline.com/2002/03/04/stories/2002030400110900.htm

5
Audit Committee: 
In the words of the Special Investigating Committee: "The Board assigned
the Audit and Compliance Committee an expanded duty to review the
transactions, but the Committee carried out the reviews only in a cursory
way." The Chair of the Audit Committee since 1985 was Mr. Robert
Jaedicke. Mr. Jaedicke, in addition to not using his expertise to perform
his role as Chair of the committee, seconded the motion in the board to
suspend the `Code of Ethics' of the company in order to allow an
employee to set up a special partnership. Setting up that entity
amounted to a conflict of interest and was specifically prohibited by the
company code. Apart from Mr. Jaedicke, the audit committee comprised
of five persons, three of whom reside outside the country. An audit
committee is almost a `working' committee and needs to meet more
frequently than a full board. One of the members, Mr. Ronnie Chan,
missed 75 per cent of the meetings in 2001.6

Too many directorships: 

Good governance suggests that an individual sitting on too many
boards looks upon it only as a sinecure for he or she will not have the
time to do a good job. Mr. Raymond Troubh, one of the directors, is a
Director of 11 public companies. In Enron's case too many of their
faults came together at the same time to cause the company to
implode. 6

Chairman and Chief Executive Officer:

 Mr. Kenneth Lay was both the Chairman and Chief Executive Officer.
For a brief while the two positions were separated when Mr. Jeff Skilling
functioned as Chief Executive Officer, and when he resigned in August
2001, Mr. Lay again took on both roles. It is considered good practice to
separate the roles of the Chairman of the Board and that of the Chief
Executive Officer. 6

Flow of information:
The Special Investigating Committee report says: "The board was denied
important information that might have led it to action, but the Board
also did not fully appreciate the significance of some of the specific
information that came before it. Moreover, if they did not have sufficient
information, they should have gone seeking it. Reports suggest that
Enron operated about 3,500 Special Purpose Entities, that is,
partnerships that shifted debt and losses off Enron's balance-sheet. If
the directors did not understand what was being reported to them, it was
their job to educate themselves more about it by asking the right
questions and getting more information. This they failed to do. 6

(December 22,2010)

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 3.2 Failure of corporate governance at WorldCom in 2002

Independence of the Board

For the board to be independence not more than two directors should be
current or former company executives, this was not in the case of
WorldCom. The board member was engaged in direct business dealings
with the said company and accepts consulting fees for services rendered
beyond that of an appointed board member5.

Quality of the Director

WorldCom boards were not including a minimum of two independent
directors with experience in the company’s core business. Ideally, one of
the board members should be a CEO of an equivalent size company. 5

Make CEOs More Accountable

The said board members proved to be ever loyal to CEO Ebbers. They, in
turn, received multiple perks, including millions of dollars in WorldCom
stock, use of the company’s private jet and financial support to pursue a
variety of individual projects.5

WorldCom seemed to meet most of the governance standards of its time.

Indeed, in several areas WorldCom exceeded the accepted norms of “best
practice” in corporate governance, even though there was little if
anything about its governance that was “good” in reality. This illustrates
the fact that good governance is not achieved by simply adhering to
“checklists” of recommended “best practices,” but is a more complex
equation that is highly dependent on the attitudes and actions or
inactions of the people involved. While not found in most descriptions of
director qualifications, “backbone” and “fortitude” may be the most
important qualities needed by a director of a public company. 7

Ebbers controlled the board’s agenda, the timing and the scope of board
review of transactions, awards of compensation, and the structure of
management. He ran the Company with iron control, and the board did
not establish itself as an independent force within the Company. The
Chairman of the Board did not have a defined role of substance, did not
control the board’s agenda, did not run the meetings and did not act as a
meaningful restraint on Ebbers.

75
http://www.cem.ulaval.ca/pdf/gershon_alhassan.pdf

Breeden, Richard C., Restoring trust,

http://news.findlaw.com/hdocs/docs/worldcom/corpgov82603rpt.pdf ( December 22,
2010)

7
WorldCom’s collapse reflected not only a financial fraud but also a major
failure of corporate governance. The Board of Directors, though
apparently unaware of the fraud, played far too small a role in the life,
direction and culture of the Company 5

4.0 REASON FOR AUDIT FAILURE

The reason of great audit failure was mainly lack of independence and
failure keeps enough professional cautiousness and professional
skepticism. Let see the reasons in details as follows;

The flaw of accounting system

The American accounting system is rule-based unlike principle-based
accounting standard is not easily evaded by Business Management and
Organization Design that enterprise plans meticulously.8

The independence of auditor is not enough

The independence is the key to ensure audit quality, and makes public
believe accounting firm. The auditor providing management consultant
service and in turn audit the same corporation impaired their
independence.

In 2001, WorldCom Inc. paid Arthur Andersen service expense about

16.8 million dollars, including audit expense 4.4 million dollars, tax
consultant service 7.6 million dollars, non-financial statements audit 1.6
million dollars, other consultation 3.2 million dollars. Enron Corp. paid
Arthur Andersen audit expense 25 million dollars, consultations and
other service expense 27 million dollars, and the total added up to 52
million dollars. 8

Problem of control model

The control includes three models: self-control, government control and
independent control. Different models had different effects. The
independence of self-control is the lowest, independent control is the
reverse. The audit failure by Arthur Andersen makes public examines
again the control system. It’s no doubt that the self-control model plays
an important role in improving the CPA profession. 8

Leveraging expertise
8
Zhao, S. & Hua, L. 2006, Study of American Audit Failure, Modern Accounting and
Auditing, http://www.accountant.org.cn/doc/acc200606/acc20060612.pdf (December
14, 2010)

8
Arthur Andersen had some of the best minds in accounting industry
were located in their Professional Standards Group and were supported
with state of the art technological and systems resources. The experts
and their support systems were used to support marketing the firm
instead of ensuring the highest quality accounting.

Experts, expert systems and technology without access to managerial

power to prevail can result in the same decisions that would be made in
the absence of such expertise.9

Mark to market
This method was for booking the value of its traders and used Special
purpose entities (SPE). They were entities designed to function for special
purpose. It was not directly disclosed, the use of Special purpose entities
(SPE) to borrow from bank for company. The company through SPE
record loan as cash generated from operation, as a result they were able
to understate the company liabilities and overstate equity and profit
thereby hiding the financial position of company investors. 10

5.0 WHAT WOULD HAVE BEEN DONE BY AUDITORS

Auditing standards have a role to play in ensuring that factors such as

objectivity, integrity and independence, factors which are essentially in
the external auditor’s performance of his responsibilities are respected.

The auditor’s provision of management consultant should not have

been there, and should be limited, this reduces the level of technical
expertise within firms and therefore their competence to conduct
audits is decreased.

The rotation of audit firm would strengthen the audit work and hence
reduce the relationship with management and the level of being
corrupted by client due to vulnerability.

The financial audit remains an important aspect of corporate governance

that makes management accountable to shareholders for its stewardship
of a company. In this regard, attention is drawn to the importance of

9
Salterio, S. Enron: Accounting expertise to the rescue,
http://cogsci.uwaterloo.ca/courses/Enron%20and%20expertise.ppt (December 20,
2010)
10
Saganga, Mussa (2010) “Creative Accounting: It’s essence, rationalization and
eccentricity” The accountant, Vol. 25, no. 4 pp 19.

9
audit committees. Audit committees do not only serve as internal
monitoring devices which support good corporate governance, they are
also considered to be mechanisms of ensuring that an appropriate
relationship exists between the auditor and the management whose
financial statements are being audited.

The external auditor’s responsibilities and the audit committee’s role in

corporate governance are fundamental complements in helping to
achieve the desired aims of corporate governance. Safeguards are
necessary to ensure that the external auditor’s expertise is maximized.
Even though external auditors play a vital role in corporate governance,
through their involvement and their examination of financial statement
and accounting policies several areas continue to give rise to problems 2

6.0 CONCLUSION AND RECOMMENDATION

The financial audit remains an important aspect of corporate governance

that makes management accountable to shareholders for its stewardship
of a company. In this regard attention is drawn to the importance of
audit committees. Audit committees do not only serve as internal
monitoring devices which support good corporate governance, they are
also considered to be mechanisms of ensuring that an appropriate
relationship exists between the auditor and the management whose
financial statements are being audited.

External auditors can impact the risk taking incentives of management

through an appropriate application of accounting policies. The external
auditor’s responsibilities and the audit committee’s role in corporate
governance are fundamental complements in helping to achieve the
desired aims of corporate governance311
The failures of corporate remain on two aspects that requiring reform,
which are the audit function and the current financial reporting model.

The essence of corporate governance is a vital tool that needs to be

respected for the existence of any company. The case Enron and
WorldCom will forever remain as a huge lesson for the development of
corporate governance and its implication Tanzania.

112
http://mpra.ub.uni-muenchen.de/15989/1/MPRA_paper_15989.pdf
(accessed on December 21, 2010)
3
Stephen Bartholomeusz, After Enron: The new reform,
http://www.austlii.edu.au/au/journals/UNSWLJ/2002/33.txt/cgi.../2002/33.rtf
(December 16, 2010)

10
BIBLIOGRAPHY

1. Victor Gaines, the Role of Corporate Governance in the Financial

Institution Industry, http://www.theiia.org/download.cfm?
file=28127(accessed on
December 21, 2010)

2. http://mpra.ub.unimuenchen.de/15989/1/MPRA_paper_15989.p
df (accessed on December 21, 2010)

3. Stephen Bartholomeusz, After Enron: The new reform,

http://www.austlii.edu.au/au/journals/UNSWLJ/2002/33.txt/cgi
.../2002/33.rtf (December 16, 2010)

4. Peter Grosvenor Munzig, Enron and the Economics of Corporate

Governance,http://www.economics.stanford.edu/files/Theses/The
ses_2003/Munzig.pd (December 14,2010)

5. http://www.cem.ulaval.ca/pdf/gershon_alhassan.pdf (December
17, 2010)

6. Gopinath. C, Corporate governance failure at Enron

http://www.thehindubusinessline.com/2002/03/04/stories/2002
030400110900.htm (December 22, 2010)

7. Breeden, Richard C., Restoring trust,

http://news.findlaw.com/hdocs/docs/worldcom/corpgov82603rpt
.pdf ( December 22, 2010)

8. Zhao, S. & Hua, L. 2006, Study of American Audit Failure, Modern

Accounting and Auditing,
http://www.accountant.org.cn/doc/acc200606/acc20060612.pdf
(December 14, 2010)

9. Salterio, S. Enron: Accounting expertise to the rescue,

http://cogsci.uwaterloo.ca/courses/Enron%20and
%20expertise.ppt (December 20, 2010)

10. Saganga, Mussa (2010) “Creative Accounting: its essence,

rationalization and eccentricity” The accountant, Vol. 25, no. 4
pp.19.

11
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