Ateneo de Zamboanga University

School of Management and Accountancy

Accountancy Department

AUDIT CASE:
ENRON CORPORATION AND ANDERSEN, LLP (CASE 4.1)

SUBMITTED BY:

Acosta, Allen Rey A.

Chua, Rhia G.
Dangase, Arvin P.
Itucas, Jens Roland F.
Pepito, Kristine Jane A.
Quemada, Alexander T.
Sontillano, Michael John S.
BSAC 2A- GROUP 3

SUBMITTED TO:
Armee Jay L. Cresmundo, CPA, MSA
EXTAUD 1-INSTRUCTOR

January 19, 2022

ENRON CORPORATION AND ANDERSEN, LLP: THE FALL OF THE TWO GIANTS
Case Assignment 1

SUMMARY OF ENRON CORPORATION AND ANDERSEN SCANDAL

The Rise of Enron Corporation
Enron Corporation is a merger of two natural-gas-transmission companies founded by
Kenneth Lay in 1985. It was composed of Houston Natural Gas Company and Omaha-based
InterNorth Incorporated. Throughout the late 1990s, Enron Corporation lost its exclusive right to
operate its pipelines due to the adaptation of a series of laws created by the United States
Congress to deregulate the sale of natural gas. However, with the help of Jeffrey Skilling, who
was mainly the consultant and later the company’s chief financial officer, Enron Corporation
progressed itself into a trader of energy derivative contracts, acting as an intermediary between
natural-gas producers and their customers. Through a fee-based contract negotiated by Enron, the
producers were able to reduce the risk of energy price volatility by establishing a fixed selling
price for their products. Enron quickly became the market leader in natural-gas contracts under
Skilling's supervision, and the business began to profit from its trading. Also, Enron's goals were
fueled by the 1990s “bull market”, which contributed to the company's fast expansion. All over
the place were deals to be made, and the corporation was ready to create a market for anything
that could be traded. It thus traded derivative contracts for a wide range of commodities, such as
energy, coal, paper, and steel. During the dot-com boom, Enron Online developed an online
trading business, and by 2001, it was completing $2.5 billion in daily online trades. To promote
high-speed trading, Enron also invested in the construction of a broadband telecommunications
network.

Enron Corporation Downfall and Bankruptcy

Enron's revenues rapidly decreased as the boom years drew to an end and the company's
energy-trading industry encountered growing competition. Under pressure from shareholders,
firm management began to conceal the problems by using dubious accounting procedures, such
as "mark-to-market accounting." The corporation was able to write unrealized future gains from
some trading contracts into current income statements using mark-to-market accounting, creating
the appearance of bigger current profits. It was also moved to so-called special purpose entities
(SPEs), which are effectively limited partnerships formed with outside parties, and the
company's troublesome operations were shifted to SPEs. Even though many corporations gave
their assets to SPEs, Enron took advantage of the practice by employing them as dumping
grounds for its failing assets. By transferring those assets to SPEs, Enron's losses seemed to be
less severe than they were because they were kept off company books. Some of those SPEs,
ironically, were controlled by Fastow himself. During this time, Arthur Andersen was not only
an auditor for Enron but also a consultant for the business. Enron went into free collapse as the
specifics of the accounting misdeeds surfaced. Fastow was sacked, and by the beginning of
November 2001, the company's stock price had dropped from a high of $90 per share in mid-
2000 to less than $12. Enron agreed to be acquired by Dynegy that month in an attempt to escape
bankruptcy. Dynegy, on the other hand, pulled out of the contract a few weeks later. Enron's
stock plummeted to less than $1 per share as a result of the announcement, reducing the value of
Enron employees' pensions, which were mostly based on the company's stock. Arthur Andersen
was also subjected to a lot of scrutinies and found guilty of destroying evidence and losing his
public accounting license.

1. What were the business risks Enron faced, and how did those risks increase the
likelihood
of material misstatements in Enron’s financial statements?

Enron faced various business risks that resulted in its management adopting fraudulent
accounting activities. The company acted as an intermediary or broker of energies exposing it to
the risk of energy-price fluctuations and other environmental concerns. As one of Enron’s
ambitions is to expand, an online trading division, Enron Online, was launched. And because of
this, its operations were mostly conducted over the Internet that resulted in the existence of high-
risk technological failures.  Moreover, due to Enron’s foreign diverse operations including in
Europe and India, they also faced several regulatory and risk profiles. The extensive use of
Special Accounting Entities (SPEs) was one major business risk that Enron has faced. Enron
manipulated its financial statements by hiding the exact amount of its liabilities, enticing its
creditors, investors, and even consumers into believing that they are making more money than
they really were.

             Due to the business risks mentioned above, Enron’s management experienced
tremendous pressure from the shareholders which caused them to misstate its financial
statements. Another reason is that Enron is highly dependent on stock prices. And lastly, the
importance of pleasing financial statements is essential in Enron’s success. The reason for this is
that it brings confidence and trust to third persons such as its partners and investors. Thus, this
triggered them to engage in fraudulent accounting practices. 

2. In your own words, summarize how Enron used SPEs to hide large amounts of company
debt.
Enron was experiencing financial difficulties causing them to engage in different
fraudulent activities. The company did not have enough money therefore they have to
make huge loans from other financial institutions. In order for Enron to hide its debts and
toxic assets from its investors and creditors, they orchestrated a scheme that uses Special
Purpose Entities (SPEs). The primary aim of this was to sell off company assets in order
to record a cash inflow and eliminate those assets and the relative liabilities therein from
Enron’s balance sheet. The use of SPEs were not illegal as long as Enron secured an
 outside investment of at least 3% of the value of assets sold to the SPEs. The SPEs
financial records are not consolidated to Enron’s. Thus, Enron took advantage of this by
borrowing money from banks and still be able to achieve a pleasing financial statement.

(3) (a) What are the responsibilities of a company’s board of directors? (b) Could the board
of directors at Enron—especially the audit committee—have prevented the fall of Enron?
(c) Should they have known about the risks and apparent lack of independence with
Enron’s SPEs? What should they have done about it?

The board of directors is the group of people that were elected to represent the
shareholders; thus, their responsibility includes not allowing the business of the company to
incur unneeded risks of serious loss to the creditors and investors. A director’s primary
responsibility is the well-being of the company as a whole and not the personal matters of
individuals who own the company or the ones at the top.

The board of directors could have done more to have prevented the downfall of Enron.
Allowing Enron to engage in a lot of high-risk accounting and off-the-books activities to portray
a better image of the company so that their stock price will increase, was no doubt a massive
mistake on the part of the directors. The fact that the company’s internal and external audits were
done by the same firm was a telling sign that trouble would soon come for the company.

The board of directors could have been stricter with the management and how the
accounts were handled. The easiest way to prevent the fall of Enron was to simply have two
different auditing teams doing the internal and external audit, as this would lessen the risk of
what happened with Enron and Andersen. Having two teams that come from different firms, and
not just from Arthur Andersen LLP, could have also saved Anderson from its downfall.

Being members of the board of directors, they should have been aware of Enron and its
misuse of SPEs. The board should have been stricter and forced the accounting team to
consolidate the SPEs and include them in Enron’s financial statements, as doing so would have
not allowed Enron to construct the network of SPEs with complicated speculations and hedges to
hide the amount of debt Enron had.

(4) Explain how “rule-based” accounting standards differ from “principle-based”

standards. How might fundamentally changing accounting standards from “bright-line”
rules to principle-based standards help prevent another Enron-like fiasco in the future?
Some argue that the trend toward the adoption of international accounting standards
represents a move toward more “principle-based” standards. Are there dangers in
removing “bright-line” rules? What difficulties might be associated with such a change?

Rule-based accounting is a methodology based on technical compliance with the law. It is

objective in the sense that what is written on papers, is what’s followed–there is a clear
distinction of what you can and can’t do. Principles-based accounting, however, is a somewhat
subjective methodology in which standards serve as guidelines more than predetermined rules. It
allows accountants to apply their professional judgment to draw out the best application/decision
to a situation.

Principles-based accounting might help to prevent another Enron-like fiasco in the future
because it isn’t absolute, unlike rule-based accounting. There is pressure in rule-based
accounting in the way that accountants/managers might alter results to match what is obligated.
The former method, however, is adjustable because there is room for professional judgment
which is grounded in high moral and ethical value systems. This allows accountants to see the
situation in full picture without disregarding integrity and character. But then again, this strength
is also the flaw of the principle-based accounting method as accountants may rationalize
aggressive accounting treatments in the name of personal interpretation. It may even become an
opportunity for fraudulent activity. 

(5) What are the auditor independence issues surrounding the provision of external
auditing services, internal auditing services, and management consulting services for the
same client? Develop arguments for why auditors should be allowed to perform these
services for the same client. Develop separate arguments for why auditors should not be
allowed to perform non-audit services for their audit clients. What is your view, and why?

The provision of such services (i.e., external auditing, internal auditing, and management
consulting) to the same client entity compromise the auditor’s independence. The following are
the conflicts involved but are not limited to: (1) Interests. Since the auditor has a commercial-
financial or other interest in the client entity, the audit firm’s objectiveness in work (judgment) is
likely to be influenced directly or indirectly. With that, the auditor in practice may or may not
conduct the audit in such a way that it meets the auditing standards. This auditor independence
issue has been evident in the case of ENRON CORPORATION AND ANDERSEN, LLP: “The
accounting firm (Andersen) had identified $51 million of misstatements in Enron's financial
statements but decided not to require corrections when Enron balked at making the adjustments
Andersen proposed… --but Andersen gave Enron's financial statements a clean opinion
nonetheless.” and (2) on Review. Since the auditor is to audit one’s work, as well as that of
others in the organization, the auditing cannot be expected to provide an opinion that is unbiased
as it is a self-review— some facts are susceptible to being overlooked. This issue has also been
apparent in the case of ENRON CORPORATION AND ANDERSEN, LLP: “In 2000, Enron
reported that it paid Andersen $52 million—$25 million for the financial statement audit work
and $27 million for consulting services. Andersen not only performed the external financial
statement audit but also carried out Enron’s internal audit function… Enron’s 2000 annual
report disclosed that one of the major projects Andersen performed in 2000 was to examine and
report on management’s assertion about the effectiveness of Enron’s system of internal
controls.” It is of utmost importance that on the part of the auditor, ethical requirements such as
independence and competence are satisfied for this ensures objectivity in carrying out one’s
work. Hence, any compromises on auditors’ independence are a must to avoid. Biases and
motives of the Auditor pose information risks for it impairs judgment. This practice— provision
of such services to the same client entity necessitated the enactment of the Sarbanes-Oxley Act
of 2002 to enhance auditors' independence. The Congress introducing the guidelines relating to
independence only goes to show how crucial an auditor’s independence is in the conduct of the
audit process.

Arguments for why auditors should be allowed to perform these services for the same client:

i. An auditor can still act independently in their service even when they are performing other
services.

ii. By having one auditor perform such services, the client saves some time and money that
would have been spent in acquiring the services of another who is likely to be unfamiliar with
the company culture.

Arguments for why auditors should not be allowed to perform non-audit services for their audit
clients:

i. An auditor may not act independently in their service when they perform other services.

ii. By having different auditors for each service, the company will benefit from multiple
viewpoints that would aid in making a more informed decision.

6. Enron and Andersen suffered severe consequences because of their perceived lack of
integrity and damaged reputations. In fact, some people believe the fall of Enron occurred
because of a form of “run on the bank.” Some argue that Andersen experienced a similar
“run on the bank” as many top clients quickly dropped the firm in the wake of Enron’s
collapse. Is the “run on the bank” analogy valid for both firms? Why or why not?
 Yes. Both firms are valid on the concept of "Run on the bank." In the case of Enron, the
resignation of  CEO Jeffrey Skilling marks the beginning of the company's downfall in the
business industry. Eventually, this resignation raised suspicion to the internal and external
analysts, particularly the SEC, which led to the investigation regarding the company's financial
statements and accounting practices. Throughout the inspection, Enron was exposed publicly that
they committed fraudulent action, resulting in the loss of reputation, trust, and confidence of
their customers, trading partners, and future investors. Before Enron's accounting scandal was
fully exposed to the public and the collapse of the stock price in the market, some Enron
employees, including Lay, were able to sell their stocks right away and retrieve their investment
since they suspected that the company's debts outweigh its actual profit. However, these
employees experienced difficulties in selling these stocks since some buyers were already
informed of Enron's bad reputation. The surge of selling the stocks amid enormous amounts of
debts depicts that the company is already near to bankruptcy. On the other hand, the analogy
"Run on the bank" in the case of Andersen arose after the investigation and revelation of one of
its largest clients. The mismanagement and delinquent audit practice committed by Andersen
towards Enron's financial statements made the other clients and business partners lose confidence
in the credibility of their services which led to the ceasing of the contract between the two
parties. In addition, Andersen lost its global practice units to rival accounting and consulting
firms. The liabilities and affiliation of Andersen to the Enron lawsuits ended its career as part of
the five big accounting firms.

7. Why do audit partners struggle with making tough accounting decisions that may be
contrary to their client’s position on an issue? What changes should the profession make to
eliminate these obstacles?

Prior to the case, we cannot deny the fact that nowadays public accounting firms are
vastly competitive businesses and they essentially want to make more revenue to achieve the end
goal—to become the biggest firm and provide the best services in the corporate industry. The
objective of public accounting firms is to give entertainment, joy and sustain good quality
services to their clients. For that reason, partners, such as the auditors, face challenges in
generating tough calls. One of the factors to consider is the internal conflict that might arise
between the auditor and their client. Thus, most of these auditors experience fear and huge
pressure. In the end, they neither want to lose a profitable client nor want to risk disappointment
among their clients. On the other hand, if the audit partner chooses to obey the client’s choice
without proper and concrete decision-making like presented in the case, it will most likely suffer
repercussions as it is considered unethical. From a legal standpoint, the legal liability of the audit
partners will increase proportionately to the audit risk. This will raise a concern from other audit
partners and stakeholders which is bad publicity. There are several ways to avoid this problem
and these are the following: (1) a change of work profession attitude and practices should be
done in which the public interest remains the top priority; (2) auditing a report or document
should always be reported to the management for transparency but also to keep the customer’s
trust; (3) auditors should undergo interventions that should gear them in making tough calls,
especially ones that place the firm in critical situations; (4) auditors should always promote and
practice transparency and honesty in auditing a document or report such as financial statements.
This will ensure the trust of the clients for the services of the firm and may also result in a better
chance of high revenue and good promotion; (5) the signed Act which is the Sarbanex- Oxley, is
dedicated to improving the concreteness and effectiveness of an auditor in a firm. It is stated
further in the provision that external auditors will no longer perform internal auditing and other
services in the same firm to avoid high pressure and bad decisions and actions in the workplace;
(6) accounting firms should use critical practices and standards. Auditors should properly
communicate with the management and find alternative solutions and provide more options for
the betterment of the firm and the client as well; (7) auditors are required to apply professional
skepticism in the firm in which it is very essential for them as it allows them to enhance their
ability to observe, identify and respond to conditions that might be a misstatement from the firm
and documents. Overall, we believe that the seven changes proposed above will help the auditors
in crafting their decisions more easily and will likely prevent them from making mistakes in the
workplace. Furthermore, we stand by the conjecture that these micro efforts will have a macro
effect to save our working industry along with the auditors from unethical workforces who are
exposed to information risks such as fraud and fictitious reports.

(8) What has been done, and what more do you believe should be done to restore the public
trust in the auditing profession and the nation’s financial reporting system?

To prevent the accident to be more likely to happen, action must be given priority. As a
result of the scandal, plenty of new rules and laws have been enacted to improve the accuracy of
financial reporting for publicly traded corporations. The Sarbanes-Oxley Act of 2002, the most
important of these, mandated severe penalties for destroying, changing, or fabricating financial
documents. The statute also made it illegal for auditing firms to work with the same customers
on the same project at the same time. Other measures adopted in this bill are aimed at restoring
confidence in the country's capital markets. The measure, for example, forced the establishment
of the SEC-supervised Public Company Accounting Oversight Board (PCAOB), effectively
terminating the profession's long-standing tradition of self-regulation. Finally, the public interest
must always come first for auditors. Companies must demonstrate their commitment to
providing accurate financial and operating information to investors and creditors regularly, and a
continuous procedure must be established to improve and maintain the quality of the information
provided to them.
 CRITERIA EXCELLENT (4) GOOD (3) SATISFACTORY (2) POOR (1) SCORE REMARKS
1 Introduction of Demonstrates Demonstrates Demonstrates some Demonstrates limited
the case thorough and insightful considerable knowledge of the case. knowledge of the case.
knowledge of the case. knowledge of the case.
2 Presentation of All components in the All components in the Most components in Most components are
the case presentation of case presentation of case the presentation of inadequately
study are thoughtfully study are addressed case study are addressed and/or not
addressed and and generally addressed and supported.
supported with a supported with a generally supported
thorough discussion of discussion of key with a discussion of key
all key issues. issues. issues.
3 Understanding Demonstrates a Demonstrates an Demonstrates an Demonstrates an
sophisticated accomplished acceptable inadequate
understanding of the understanding of the understanding of the understanding of the
case. case. case. case.
4 Links to Course Excellent research into Good research and Limited research and Incomplete research
Readings and the issues with clearly documented links to documented links to and links to any
Additional documented links to the class (and/or any readings. readings.
Research class (and/or outside) outside) readings.
readings.
5 Writing Professionalism evident Minor mistakes in Several mistakes in Many spelling,
Mechanics in spelling, grammar, spelling, grammar, spelling, grammar, punctuation, grammar,
punctuation, sentence punctuation, and punctuation, and and sentence structure
structure and clarity of sentence structure. sentence structure. errors.
writing.
TOTAL SCORE /20
Ateneo de Zamboanga University
School of Management and Accountancy Accountancy Department

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