A REPORT

ON
Enron Corporation: A Case Study
Course Name: Audit Risk and Control
Course Code: AIS 5204

Prepared For:

Abdul Alim Baser

Associate Professor

Department of Accounting and Information Systems

University of Barishal

Prepared By:

Group-01
Group Members ID No.
Lima Akter Antora 21 AIS 002
Abdur Rahim 21 AIS 003

Sharifa Sadia Akter 21 AIS 016

Prince Khan 21 AIS 039
Md Jashim Uddin 21 AIS 043

Date of Submission: 10th May, 2023

 Acknowledgement
This is our pleasure that we have successfully completed our report by the grace of almighty Allah.
We want to convey our heartfelt respect and cordial thank to Abdul Alim Baser, Associate Professor,
University of Barishal for his encouragement, guidance, advices and valuable supervision. We
consider ourselves very fortunate to have been given the opportunity to create this report under his
supervision and direction. It would have been difficult for us to complete this paper without his
guidance.

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 Letter of transmittal
th
Date: 10 May, 2023
To
Abdul Alim Baser
Associate Professor
Dept. of Accounting and Information Systems
University of Barishal.
Sub: Submission of the report on “Enron Corporation: A Case Study”.
Dear Sir,
With due respect, we would like to inform you that we are the student of the Accounting and
Information Systems Department. We are submitting our report on the “Enron Corporation: A
Case Study” with great pleasure. This report has been informative, useful, and insightful to us. We
did our best to write an effective report. We acquired this information from a variety of sources.
To prepare this report, we did my best possible. We will gladly provide you with any additional
explanations or clarifications you may require. We will be thankful if you kindly approve this effort.
Sincerely Yours,
The members of Group-01
MBA, 2nd Semester
Session: 2020-2021
Dept. of Accounting and Information Systems
Faculty of Business Studies
University of Barishal

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 Table of Contents
Acknowledgement ........................................................................................................................................... 2
Letter of transmittal ......................................................................................................................................... 3
Chapter 01: Overview of Enron Corporation & Andersen (Arthur) & Co. ....................................................... 6
1.1 Preface of Enron Corporation ................................................................................................................ 6
1.2 History of Enron Corporation ................................................................................................................. 6
1.2.1 Birth of the Company ...................................................................................................................... 6
1.2.2 Public Offerings in 1940s ................................................................................................................ 6
1.2.3 Growth through Acquisitions .......................................................................................................... 7
1.2.4 Rename to Enron ............................................................................................................................ 7
1.2.5 Enron: Before Collapse.................................................................................................................... 7
1.3 Enron’s Corporate Profile ...................................................................................................................... 8
1.3.1 Central Management of Enron Corporation ................................................................................... 8
1.3.2 Products of Enron Corporation ....................................................................................................... 8
1.3.3 Enron’s Financial Performance (1996-2000)................................................................................... 9
1.4 Overview of Arthur Andersen & Co. ...................................................................................................... 9
1.5 Conclusion ............................................................................................................................................ 10
Chapter 02: The Enron Collapse..................................................................................................................... 11
2.1 The Fall of Enron .................................................................................................................................. 11
2.2 Why Enron Fell from Grace .................................................................................................................. 12
2.2.1 Special Purpose Entities (SPE) ....................................................................................................... 12
2.2.2 Accounting Issue ........................................................................................................................... 13
2.2.3 The Crash of Enron ........................................................................................................................ 16
2.2.4 Enron’s Auditor (Arthur Andersen & Co.) ..................................................................................... 16
2.2.5 Corporate governance .................................................................................................................. 17
2.2.6 Links with the Government (Bush Administration) ...................................................................... 18
2.2.7 The Link of Enron with the British Front ....................................................................................... 19
2.3 Who was morally responsible for the collapse of ENRON? ................................................................. 19
2.4 The consequences of Enron Collapse .................................................................................................. 20
2.4.1 The Victim: Employees and Pension Fund Holders ....................................................................... 21
2.4.2 Creation of Sarbanes-Oxley Act, 2002 .......................................................................................... 21
2.5 Punishment .......................................................................................................................................... 22
2.5.1 What Happened to Arthur Andersen? .......................................................................................... 23
2.5.2 From a "Big 5" to Collapse ............................................................................................................ 23

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 2.6 What then is the Solution? .................................................................................................................. 23
2.7 Three lessons from Enron collapse ...................................................................................................... 24
2.8 What is the Andersen Effect? .............................................................................................................. 25
2.9 Conclusion ............................................................................................................................................ 25
Chapter: 03 Solution of the Case Questions .................................................................................................. 26
3.1 Questions & Solutions of Case 1.1 Enron Corporation ........................................................................ 26
3.2 Conclusion ............................................................................................................................................ 28
References ..................................................................................................................................................... 29

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 Chapter 01: Overview of Enron Corporation & Andersen (Arthur) & Co.
1.1 Preface of Enron Corporation
Enron Corporation was an American energy,
commodities, and services providing company based in
Houston, Texas. Before its bankruptcy on December 2,
2001, Enron employed approximately 20,000 staff and
was one of the world's major electricity, natural gas,
communications, and pulp and paper companies, with
claimed revenues of nearly $111 billion during 2000.
Fortune, an American business magazine, named Enron
"America's Most Innovative Company" for six
consecutive years. The story ends with the bankruptcy of
one of America's largest corporations. Enron's collapse
affected the lives of thousands of employees,
shareholders and other investors. At the end of 2001, it
was revealed that its reported financial condition was sustained by an institutionalized,
systematic, and creatively planned accounting fraud, known since as the Enron scandal. Enron
has since become a well-known example of willful corporate fraud and corruption. The scandal
also brought into the question of the accounting practices and activities of many corporations
in the United States and was a factor in the enactment of the Sarbanes–Oxley Act of 20021. The
scandal also affected the greater business world by causing the dissolution of the Arthur
Andersen accounting firm.

1.2 History of Enron Corporation

1.2.1 Birth of the Company

Enron began as Northern Natural Gas Company, organized in Omaha, Nebraska, in 1930 by
three other companies. North American Light & Power Company and United Light & Railways
Company each held a 35 percent stake in the new enterprise, while Lone Star Gas Corporation
owned the remaining 30 percent. The company's founding came just a few months after the
stock market crash of 19292, an inauspicious time to launch a new venture. Several aspects of
the Great Depression actually worked in Northern's favor, however. Consumers initially were
not enthusiastic about natural gas as a heating fuel, but its low cost led to its acceptance during
tough economic times. High unemployment brought the new company a ready supply of cheap
labor to build its pipeline system. In addition, the 24-inch steel pipe, which could transport six
times the amount of gas carried by 12-inch cast iron pipe, had just been developed. Northern
grew rapidly in the 1930s, doubling its system capacity within two years of its incorporation
and bringing the first natural gas supply to the state of Minnesota.
1.2.2 Public Offerings in 1940s
The 1940s brought changes in Northern's regulation and ownership. In 1941, United Light &
Railways sold its share of Northern to the public, and in 1942 Lone Star Gas distributed its
holdings to its stockholders. North American Light & Power would hold on to its stake until

1
The Sarbanes-Oxley Act of 2002 (often shortened to SOX) is legislation passed by the U.S. Congress to protect
shareholders and the general public from accounting errors and fraudulent practices in the enterprise, as well as
improve the accuracy of corporate disclosures. The U.S. Securities and Exchange Commission (SEC) administers
the act, which sets deadlines for compliance and publishes rules on requirements.
2
The Wall Street Crash of 1929, also known as Black Tuesday (October 29) that began on October 24, 1929 and was
the most devastating stock market crash in the history of the United States.

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1947, when it sold its shares to underwriters who then offered the stock to the public. Northern
was listed on the New York Stock Exchange that year.

1.2.3 Growth through Acquisitions

Northern continued expanding during the 1970s. During the 1970s, Northern became a
principal investor in the development of the Alaskan pipeline3. When completed, that pipeline
allowed Northern to tap vast natural gas reserves it had acquired in Canada. In 1980, Northern
changed its name to InterNorth, Inc. Over the next few years, company management extended
the scope of the company’s operations by investing in ventures outside of the natural gas
industry, including oil exploration, chemicals, coal mining, and fuel-trading operations. But the
company’s principal focus remained the natural gas industry. In 1985,
InterNorth purchased Houston Natural Gas Company for $2.3 billion. That acquisition resulted
in InterNorth controlling a 40,000-mile network of natural gas pipelines and allowed it to
achieve its long-sought goal of becoming the largest natural gas company in the United States.

1.2.4 Rename to Enron

In 1986, InterNorth changed its name to Enron. Kenneth Lay, the former chairman of Houston
Natural Gas, emerged as the top executive of the newly created firm that chose Houston, Texas,
as its corporate headquarters. Lay quickly adopted the aggressive growth strategy that had long
dominated the management policies of InterNorth and its predecessor. Lay hired Jeffrey
Skilling to serve as one of his top subordinates. During the 1990s, Skilling developed and
implemented a plan to transform Enron from a conventional natural gas supplier into an energy-
trading company that served as an intermediary between producers of energy products,
principally natural gas and electricity, and end users of those commodities. In early 2001,
Skilling assumed Lay’s position as Enron’s chief executive officer (CEO), although Lay
retained the title of chairman of the board.

1.2.5 Enron: Before Collapse

Enron’s 2000 annual report discussed the company’s four principal lines of business. Energy
Wholesale Services ranked as the company’s largest revenue producer. That division’s 60
percent increase in transaction volume during 2000 was fueled by the rapid development of
EnronOnline, a B2B (business-to-business) electronic marketplace for the energy industries
created in late 1999 by Enron. During fiscal 2000 alone, EnronOnline processed more than
$335 billion of transactions, easily making Enron the largest e-commerce company in the
world. On the other hand Lay’s position as the chief executive of the nation’s seventh-largest
firm gave him direct access to key political and governmental officials. In June 2001, Skilling
was singled out as “the No. 1 CEO in the entire country,” while Enron was hailed as “America’s
most innovative company. Enron’s chief financial officer (CFO) Andrew Fastow was
recognized for creating the financial infrastructure for one of the nation’s largest and most
complex companies. In 1999, CFO Magazine presented Fastow the Excellence Award for
Capital Structure Management for his “pioneering work on unique financing techniques”.

3
One of the world's largest pipeline systems. It is 800 miles (1,287 km) pipeline with the diameter of 48 inches (122
cm) that conveys oil from Prudhoe Bay, to Valdez, Alaska.

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1.3 Enron’s Corporate Profile

1.3.1 Central Management of Enron Corporation

 Kenneth Lay: Chairman, and Chief executive officer
 Jeffrey Skilling: President, Chief operating officer, and CEO (February–August
2001)
 Andrew Fastow: Chief financial officer
 Triton Dietrich: Chief accounting officer
 Rebecca Mark-Jusbasche: CEO of Enron International and Azurix
 Lou Pai: CEO of Enron Energy Services
 Forrest Hoglund: CEO of Enron Oil and Gas
 Dennis Ulak: President of Enron Oil and Gas International
 Jeffrey Sherrick: President of Enron Global Exploration & Production Inc.
 Richard Gallagher: Head of Enron Wholesale Global International Group
 Kenneth "Ken" Rice: CEO of Enron Wholesale and Enron Broadband Services
 J. Clifford Baxter: CEO of Enron North America
 Sherron Watkins: Head of Enron Global Finance
 Jim Derrick: Enron General Counsel
 Mark Koenig: Head of Enron Investor Relations
 Joan Foley: Head of Enron Human Resources
 Richard Kinder: President and COO of Enron (1990-December 1996); co-founder
of Kinder Morgan
 Greg Whalley: President and COO of Enron (August 2001– Bankruptcy)
 Jeff McMahon: CFO of Enron (October 2001-Bankruptcy)

1.3.2 Products of Enron Corporation

Enron traded in more than 30 different products, including the following:

• Products traded on EnronOnline

 Petrochemicals
 Plastics
 Power
 Pulp and paper
 Steel
 Weather Risk Management
• Oil and LNG transportation
• Broadband
• Principal investments
• Risk management for commodities
• Shipping / freight
• Streaming media
• Water and wastewater

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1.3.3 Enron’s Financial Performance (1996-2000)

Exhibit: 1 Enron Corporation 2000’s Annual Report Financial Highlight Table

(In millions except per share amount)
Source: Enron, 2000
1.4 Overview of Arthur Andersen & Co.
Arthur Andersen & Co. is an accounting firm providing services in assurance, taxation, corporate
finance, and more. It is considered as one of the “Big Five” accounting firms among
PricewaterhouseCoopers, Deloitte Touche Tohmatsu, Ernst & Young, and KPMG. This pioneering
accounting services firm was founded in Chicago in 1913 by a young Northwestern University
professor, Arthur Andersen, and a partner named Clarence DeLany. The firm started with two
partners and six employees, who offered customers help with new federal income taxes and other
accounting problems. During the 1920s, Andersen opened six new offices across the country, and
annual billings rose to $2 million. The firm weathered the Great Depression and continued to expand
after the founder's death in 1947. Between 1947 and 1973, Andersen's client base rose from 2,300
to 50,000, and the Chicago office increased from about 250 to more than 1,500 employees.
Expansion continued during the late twentieth century, as the company became increasingly
international and created a fast-growing management consulting division. In 1989, Arthur Andersen
and Andersen Consulting became separate units, which were controlled by Arthur Andersen & Co.,
S.C.; this multibillion-dollar parent company soon became known as Andersen Worldwide. At the

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beginning of the twenty-first century, Andersen Consulting changed its name to Accenture Ltd.; and
Arthur Andersen became simply Andersen. At that time, the consulting and accounting groups
together employed nearly 8,500 Chicago-area residents. In the wake of the Enron scandal and the
firm's indictment for obstruction of justice in 2002, Andersen ceased auditing clients in 2002 and
began selling its overseas assets to other firms.

1.5 Conclusion
The Enron Scandal is considered to be one of the most notorious within American history. At the
time of Enron's collapse, it was the biggest corporate bankruptcy ever to hit the financial world. The
Enron scandal drew attention to accounting and corporate fraud, as its shareholders lost $74 billion
in the four years leading up to its bankruptcy, and its employees lost billions in pension benefits.
Arthur Andersen & Co. is considered as one of the “Big Five” accounting firms. In the wake of the
Enron scandal and the firm's indictment for obstruction of justice in 2002, Andersen ceased auditing
clients in 2002 and began selling its overseas assets to other firms.

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 Chapter 02: The Enron Collapse

Source: bbc.com.uk
2.1 The Fall of Enron
In May 2001, Enron’s executive Clifford Baxter left the company, apparently in
uncontroversial circumstances. It was rumored that Baxter, who later committed suicide, had
clashed with Jeff Skilling (Enron’s CEO), over the righteousness of Enron’s partnership
transactions.

On 14th August 2001, Jeff Skilling resigned as Chief Executive, citing personal reasons and
Kenneth Lay became Chief Executive Officer. Skilling’s departure was prompted by concerns
over Enron's bungled accounting and bad management.

In mid-August 2001, Sherron Watkins, Enron’s Corporate Development Executive, who was
later referred to as the “whistleblower” in the Enron scandal, wrote a letter to Kenneth Lay
warning him of accounting irregularities that could pose a threat to the company. This
development shocked investors who suddenly panicked. The lack of transparency sent a selling
wave in the market. Investors sold millions of shares, knocking almost $ 4 off the price to less
than $40 over the course of the third week of August 2001. In spite of the drop in price,
management still insisted all was well. Despite the air of impending doom, Kenneth Lay found
two banks willing to extend credit. But the worst of revelations were to come yet.

On 8th November 2001, the company took the highly unusual move of restating its profits for
the past four years. Enron effectively admitted that it had inflated its profits by concealing debts
in its complicated partnership arrangements (Special Purpose Entities).

On 9th November 2001, the humiliation of Enron appeared complete as it entered negotiations
to be taken over by its much smaller rival, Dynegy. The following graph shows how Enron’s
restated accounts.

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 Reported and revised income, debt and shareholder equity 1997 – 2000 following special partnership revelations;
Source: Enron, 2000

Enron filed for bankruptcy in December 2001 and filed a suit against Dynegy for pulling out
of the proposed merger. Enron’s share price collapsed from around $ 95 to below $ 1. Enron’s
employees lost their savings as well as their jobs. Mr. Kenneth Lay, the once renowned
visionary chairman of the firm, resigned in January 2002.

It appears now that the phenomenal success of Enron was a daydream and it seems to have
sunk into a financial predicament that is largely of its own creation. In just sixteen years, Enron
grew into one of America's largest companies; however, its success was based on artificially
inflated profits, questionable accounting practices and fraud. Several of the company’s
businesses were losing operations; a fact that was concealed from investors using off balance
sheet vehicles or structured finance vehicles.

2.2 Why Enron Fell from Grace

2.2.1 Special Purpose Entities (SPE)

Enron used special purpose entities—limited partnerships or companies created to fulfill a
temporary or specific purpose to fund or manage risks associated with specific assets. The company
elected to disclose minimal details on its use of "special purpose entities". These shell companies
were created by a sponsor, but funded by independent equity investors and debt financing. For
financial reporting purposes, a series of rules dictate whether a special purpose entity is a separate
entity from the sponsor. In total, by 2001, Enron had used hundreds of special purpose entities to
hide its debt. The company used a number of special purpose entities, such as partnerships in its
Thomas and Condor tax shelters, financial asset securitization investment trusts (FASITs) in the
Apache deal, real estate mortgage investment conduits (REMICs) in the Steele deal, and REMICs
and real estate investment trusts (REITs) in the Cochise deal.

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The special purpose entities were Tobashi schemes used for more than just circumventing
accounting conventions. As a result of one violation, Enron's balance sheet understated its liabilities
and overstated its equity, and its earnings were overstated. Enron disclosed to its shareholders that
it had hedged downside risk in its own illiquid investments using special purpose entities. However,
investors were oblivious to the fact that the special purpose entities were actually using the
company's own stock and financial guarantees to finance these hedges. This prevented Enron from
being protected from the downside risk.

2.2.2 Accounting Issue

Revenue recognition
Enron earned profits by providing services such as wholesale trading and risk management in
addition to building and maintaining electric power plants, natural gas pipelines, storage, and
processing facilities. When accepting the risk of buying and selling products, merchants are
allowed to report the selling price as revenues and the products' costs as cost of goods sold. In
contrast, an "agent" provides a service to the customer, but does not take the same risks as
merchants for buying and selling. Service providers, when classified as agents, may report
trading and brokerage fees as revenue, although not for the full value of the transaction.

Although trading companies such as Goldman Sachs and Merrill Lynch used the conventional
"agent model" for reporting revenue (where only the trading or brokerage fee would be reported
as revenue), Enron instead elected to report the entire value of each of its trades as revenue.
This "merchant model" was considered much more aggressive in the accounting interpretation
than the agent model. Enron's method of reporting inflated trading revenue was later adopted
by other companies in the energy trading industry in an attempt to stay competitive with the
company's large increase in revenue. Other energy companies such as Duke Energy, Reliant
Energy, and Dynegy joined Enron in the largest 50 of the revenue-based Fortune 500 owing
mainly to their adoption of the same trading revenue accounting as Enron.

Between 1996 and 2000, Enron's revenues increased by more than 750%, rising from $13.3
billion in 1996 to $100.7 billion in 2000. This expansion of 65% per year was extraordinary in
any industry, including the energy industry, which typically considered growth of 2–3% per
year to be respectable. For just the first nine months of 2001, Enron reported $138.7 billion in
revenues, placing the company at the sixth position on the Fortune Global 500.
Enron also used creative accounting tricks and purposefully misclassified loan transactions as
sales close to quarterly reporting deadlines, similar to the Lehman Brothers Repo 105 scheme
in the 2008 financial crisis, or the currency swap concealment of Greek debt by Goldman Sachs.
In Enron's case, Merrill Lynch bought Nigerian barges with an alleged buyback guarantee by
Enron shortly before the earnings deadline. According to the government, Enron misreported
a bridge loan as a true sale, then bought back the barges a few months later. Merrill Lynch
executives were tried and in November 2004 convicted for aiding Enron in fraudulent
accounting activities. These charges were thrown out on appeal in 2006, after the Merrill Lynch
executives had spent nearly a year in prison, with the 5th U.S. Circuit Court of Appeals in New
Orleans calling the conspiracy and wire fraud charges "flawed". Expert observers said that the
reversal was highly unusual for the 5th Circuit, commenting that the conviction must have had

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serious issues in order to be overturned. The Justice Department decided not to retry the case
after the reversal of the verdict.
Mark-to-market accounting
In each time period, the company listed actual costs of supplying the gas and actual revenues
received from selling it. However, Enron adopted mark-to-market accounting, citing that it
would reflect “true economic value.” Enron became the first non-financial company to use the
method to account for its complex long-term contracts. Mark-to-market accounting requires
that once a long-term contract was signed, income was estimated as the present value of net
future cash flows. Due to the large discrepancies of attempting to match profits and cash,
investors were typically given false or misleading reports.
Owing to the large discrepancies between reported profits and cash, investors were typically
given false or misleading reports. Under this method, income from projects could be recorded,
although the firm might never have received the money, with this income increasing financial
earnings on the books. However, because in future years the profits could not be included, new
and additional income had to be included from more projects to develop additional growth to
appease investors. As one Enron competitor stated, "If you accelerate your income, then you
have to keep doing more and more deals to show the same or rising income. "Despite potential
pitfalls, the U.S. Securities and Exchange Commission (SEC) approved the accounting method
for Enron in its trading of natural gas futures contracts on January 30, 1992. However, Enron
later expanded its use to other areas in the company to help it meet Wall Street projections.

For one contract, in July 2000, Enron and Blockbuster Video signed a 20-year agreement to
introduce on-demand entertainment to various U.S. cities by year's end. After several pilot
projects, Enron claimed estimated profits of more than $110 million from the deal, even though
analysts questioned the technical viability and market demand of the service. When the network
failed to work, Blockbuster withdrew from the contract. Enron continued to claim future
profits, even though the deal resulted in a loss.

Source: Wall Street Club

Inadequate financial disclosures

Enron: A Financial Reporting Failure (Catanach Jr. and Rhoades-Catanach, 2003) examines
the lack and complexity of incomplete balance sheet and profit and loss statement figures.
Enron had overstated their net income and stockholder’s equity by US$1.07 billion within their

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final two years of operations as they failed to consolidate their subsidiary, Raptors. In addition,
they had understated their liabilities by up to US$711 million and their quarterly reports
indicated previous overstatements within the stockholder’s equity of US $828 million. This
resulted in the return on capital being incorrect as they purposely undervalued their debt to
generate higher profits.

Other accounting issues

Enron made a habit of booking costs of cancelled projects as assets, with the rationale that no
official letter had stated that the project was cancelled. This method was known as “the
snowball”, and although it was initially dictated that snowballs stay under $90 million, it was
later extended to $200 million. In 1998, when analysts were given a tour of the Enron Energy
Services office, they were impressed with how the employees were working so vigorously. In
reality, Skilling had moved other employees to the office from other departments (instructing
them to pretend to work hard) to create the appearance that the division was bigger than it was.
This ruse was used several times to fool analysts about the progress of different areas of Enron
to help improve the stock price.

Enron was one of the first amongst energy companies to begin trading through the internet,
offering a free service that attracted a vast amount of customers. But while Enron boasted about
the value of products that it bought and sold online around $880 billion in just two years, the
company remained silent about whether these trading operations were actually making any
money. It is believed that Enron began to use sophisticated accounting techniques to keep its
share price high, raise investment against its own assets and stock and maintain the impression
of a highly successful company. These techniques are referred to as aggressive earnings
management techniques. Losses from its books if it passed these “assets” to these partnerships.
Equally, investment money flowing into Enron from new partnerships ended up on the books
as profits, even though it was linked to specific ventures that were not yet up and running. It
now appears that Enron used many manipulative accounting practices especially in transactions
with Special Purpose Entities (SPE) to decrease losses, enlarge profits, and keep debt away
from its financial statements in order to enhance its credit rating and protect its credibility in
the market.
The main reason behind these practices was to accomplish favorable financial statement results, not
to achieve economic objectives or transfer risk. These partnerships would have been considered
legal if reported according to present accounting rules or what is known as “applicable accounting
rules”. Although these practices were generally disclosed to Enron’s investors, the disclosure was
inadequate. This inadequacy may have stemmed from conflict of interest to avoid revealing, the
extent to which some top Enron executives were enriching themselves, which simply represents
fraud. Another explanation may relate to Enron’s governance whereby Enron’s structured finance
transactions were so complex that disclosure becomes necessarily imperfect. Therefore Enron’s
investors had to rely on their business judgment of Enron’s management, but such reliance failed
due to a tangled web of conflicts of interests. This becomes crystal clear when it was known that
most of the senior Enron executives, especially Andrew Fastow, served as the SPE’s principals,
receiving massive amounts of compensation and returns, in order to skew their loyalty in favor of
the SPEs.

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2.2.3 The Crash of Enron

The shockwaves of the corporate crash resonated worldwide as investors around the world
demanded answers. Congressional hearings began in December 2001. Four of Enron's most
senior executives (Andrew Fastow, Richard Buy, Michael Kopper and Kenneth Lay) pleaded
Fifth Amendment protection against self-incrimination and refused to testify.

In January 2002, the US department of justice announced a criminal investigation. For the
average layman, the collapse of Enron is a scandal of a major energy provider that used to be
the seventh largest corporation in America and became the biggest bankruptcy in the US
corporate history. As revelations of the Enron affair continue to tumble out, employees and
investors are furious at the way a senior executive behaved and at how auditors, analysts, banks,
rating agencies and regulators turned a blind eye to what was going on.

The Enron fiasco is an unprecedented situation. This was a company with an extraordinary
complex and risky business model that entered into highly questionable transactions. The
market capitalization of Enron had reached exceptional valuations relative to the realism of the
company’s ability to produce recurring excess cash flow. What finally brought the company
down is finalized? Internal policies, investment advisors, investment banks, undetermined
criminal activity, poor auditing, and poor rating probably all played a role in its rapid demise.

2.2.4 Enron’s Auditor (Arthur Andersen & Co.)

Arthur Andersen & Co., one of the world's five leading accounting firms, was Enron’s auditing
firm. This means that Andersen’s job was to check that the company’s accounts were a fair
reflection of what was really going on. As such, Andersen should have been the first line of
defense in the case of any fraud or deception.

Threats of independence
There were several threats to independence which occurred between the two partied as the
primary auditor, Arthur Andersen, and Enron. They had engaged in the same unethical desire
to maximize profit through not applying the necessary requirements stated in the independence
declaration. According to Zelizer (2002), the two firms were displaying ‘inappropriate and
atypical’ familiarity threats as the employees of Arthur Andersen engaged in frequent voluntary
social activities including ski trips and charity fundraisers in which Enron employees also
participated in their auditors activities.

Conflict of interest
Conflict of interest occurred within Enron management and Arthur Andersen through the
examination of the consulting fees as 27 percent of the auditors overall fees were generated
through Enron (Healy and Palepu, 2003). The auditor’s lack of professional behavior and
competence might have been a result of clear incentives that were appealing to the auditor. As
the written assurance report has not met ACA and ASB standards, there is a clear breach of
standard of care in which the damages that had occurred forced the bankruptcy of Enron. Arthur
and Andersen and investors can argue that Enron were contributory negligible as they did not
uphold their standard of care in preparing true and fair financial statements (Higson, 2001).

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This conflict of interest has instigated limitations of completeness in Enron’s financial
statements through exploitation of Generally Accepted Accounting Principles (GAAP). This
has led to an increase in audit risk as material and pervasive misstatements were not recognized.

Inadequate auditor opinion

The original audit for Enron was an unqualified opinion, where the auditor stated that the
financial statements were presented true and fair and was in accordance with the GAAP when
the actual errors were so severe it led to Enron’s corporate downfall (Million, 2003). The
correct opinion should have been an adverse opinion, with an emphasis of matter as the
principles of GAAP were inadequate throughout the entire disclosure within their financial
statements. Enron was not acting true and fair in the preparation and presentation of their
financial report as there was incompleteness within their balance sheet and income statement.
The material and pervasiveness of the report suggests that Enron were operating on a going
concern basis.
As part of the auditor’s responsibility in giving reasonable assurance on the financial report,
acquiring sufficient and appropriate evidence is required. The procedures of substantive tests
are performed on account balances, class of transaction and disclosures that do not only reduce
detection risk and audit risk, but to conclude that there is reasonable assurance throughout the
financial report. The auditor did not detect the process of Enron’s flatulent consolidations to
hide losses and debt from investors and the fair value of merchant investments were not truthful
or valid.For example, Enron’s accounting for stock was inadequately disclosed causing conflict
of interest through understating the liability and overstating Owner’s Equity to satisfy
stakeholders (Benson and Hartgraves, 2002). Arthur Andersen may have labelled their
detection risk as ‘low’ to ensure trust in the inherent and control risk. According to Lev (2002),
Enron’s internal procedures indicate that due to their high amount of intangible assets, the
inherent risk would be greater as the economic value added to the firm would have diminished
faster than their physical assets.

Destruction of documents
The day Enron was subpoenaed by the SEC.
Andersen employees and partners "worked
overtime" to destroy documents. The destruction
was so extensive that "dozens of large trucks
filled with Enron documents" were sent to
Houston to be shredded, the indictment noted.

2.2.5 Corporate governance

The task of the board of directors is to oversee the company’s activities and thereby maximize its
value. Further, it has to fulfill three specific functions: have expertized members, ensure the
company does not breach any law and that information given to external are accurate as well as to
evolve a business plan. However, not complying with these requirements has led to Enron’s
corporate failure. The involvement of the board and its wrong-doing will be explained in the
following.
On the one hand, Enron’s board at least partially achieved these requirements. It consisted of several
well expertized and experienced individuals from business, legal and political areas. However,
financial structures of Enron were greatly complex and difficult to understand for external. Even if
they had tried to understand the structures they would have probably gotten confused.

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Further reasons why the board did not discover any inconsistencies in the firm’s statements will be
outlined at this point.

Firstly, the board was heavily deceived by management, in particular by Skilling and Lay. They did
not have full access to information and those information they received were falsified or incomplete.
Secondly, members of Enron’s board were not independent since a lot of the directors found
themselves in a conflict of interest as they also provided capital for special purpose entities or
peculiar donations have been made to chiefly related companies. For example, one of the director
was also chairman at a cancer center and Enron started to pay for this particular center since then.
Thirdly, corporate governance mixes in 2001 existed but their outcome did not correspond to the
intention of their creators. By using the example of Enron’s audit committee which was a
subcommittee of the board the problem of the existing mixes becomes obvious: Members of the
committee had also been paid with stock. This conduct might have encouraged them to help cover
up discrepancies in financial statements since an increasing stock value was also profitable for them.
On the other hand, Enron had a tough and aggressive corporate culture. Each decision was based on
how to raise the stock’s price; norms and ethical values were neglected.
For instance, a remuneration and evaluation system was established which allowed to assess
employees’ performance. Their overall performance and commitment for Enron was scaled into a
ranking from 1 to 5. With 1 being the lowest category the respective employee risked being fired if
performance does not improve in the close future. Moreover, good performance was compensated
with stock and employees were also heavily encouraged to invest cash-based compensation in stock.
In addition, corporate culture was based on mistrust. Management purposely kept division separate
and independent from each other in order to increase competition and achieve better results. Further,
nobody was able to get a big picture of Enron and understand its complex structures.

2.2.6 Links with the Government (Bush Administration)

In spite of the fact that there are no suggestions currently that there were any illegal connections
between the current US administration and Enron officials, there are close links that exist
between Enron and the current administration at all levels whether personal, social, financial,
professional or political. According to reports, thirty five administration officials have held
Enron stock, some had six figure investments. Several, less senior officials, have served as paid
consultants for Enron.
According to the US Center for Public Integrity, Lay (CEO of Enron) and Enron donated more
than $ 500,000 to the Bush campaign, thus making Enron the President’s largest single patron.
Bush has championed some issues Enron considered important, such as deregulating utilities
and limiting compensation awards. Bush has also favored more oil exploration and drilling in
spite of opposition from environmentalists.
As for the US Vice President, Dick Cheney, he is alleged to have met Enron executives four
times in 2001 to discuss energy policy. Cheney’s critics say that no company in the US stood
to gain more from the energy policies than Enron. Later the General Accounting Office, the
investigative arm of the US Congress, demanded that the Vice President releases documents
relating to the formulation of government energy policy but he resisted. It is also known that
Cheney was the former Chief Executive of an oil services company named Halliburton, which
built the Enron Field stadium in Houston, when Mr. Cheney was its Chief Executive. Paul
O’Neil, the current US Treasury Secretary, had been contacted by Lay who asked O'Neil to
encourage US banks to extend their credit to Enron, a request refused by O’Neil. SEC Chairman

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Harvey Pitts was hand-picked by Lay for the position, due to his notorious aversion to
governmental regulation of any kind.

2.2.7 The Link of Enron with the British Front

Shock waves of the Enron scandal have been felt in Britain too, where Enron acted as a sponsor
of the two main political parties, Labor and Conservatives. The Labor party was accused of
taking Enron’s money in return for access to government ministers. The party had apparently
changed its policy on gas-fired power stations after being lobbied by companies, including
Enron. This was seen by some as possible evidence of Enron's influence on government policy.
However, the UK Government insists its links with Enron have neither changed policy nor
bought access to ministers. The row has renewed campaigners’ calls for political parties to be
funded by the state rather than relying on business donations.
A second front of allegations emerged over Labor’s close ties with Andersen, Enron’s
accountants, a company barred from government work for failing to prevent the DeLorean car
company collapse. This ban was later lifted, which has caused the rise of awkward questions
faced by the Labor party now. Furthermore, Lord Wakeham, a former Conservative Cabinet
Minister and a nonexecutive director in Enron. Lord Wakeham served on the audit committee
that was meant to oversee Enron’s auditing procedures, which is at the heart of the scandal, and
supposed to protect shareholders’ interests. In response to these allegations, Lord Wakeham
stepped down as Chairman of the Media Watchdog, the Press Complaints Commission (PCC).

2.3 Who was morally responsible for the collapse of ENRON?

From Individuals’ Angle

As corporate acts originate in the choices and actions of human individuals, it is these individuals
who must be seen as the primary bearers of moral duties and moral responsibility. The then chairman
of the board, Kenneth Lay, and CEO, Jeffrey Skilling, to allowed the then CFO, Andrew Fastow, to
build private cooperate institution secretly and then transferred the property illegally. The CFO,
Andrew Fastow, violated his professional ethics and took the crime of malfeasance. The superior,
the chairman of the board of Kenneth Lay and CEO

Jeffrey Skilling, ordered conspiratorial employees to carry out an act that both of them knowing is
wrong, these employees are also morally responsible for the act. The courts will determine the facts
but regardless of the legal outcome, Enron senior management gets a failing grade on truth and
disclosure. The purpose of ethics is to enable recognition of how a particular situation will be
perceived. At a certain level, it hardly matters what the courts decide. Enron is bankrupt—which is
what happened to the company and its officers before a single day in court. But no company
engaging in similar practices can derive encouragement for any suits that might be terminated in
Enron’s favor. The damage to company reputation through a negative perception of corporate ethics
has already been done. Arthur Andersen violated its industry specifications as a famous certified
public accountant.

From Corporation’s Angle

The acts of a corporation's managers are attributed to the corporation so long as the managers act
within their authority. However, the shareholders of Enron didn't know and realize this matter from
the superficial high stock price. Therefore, the whole corporation was not of responsibility for this

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scandal. Actually, if the board and other shareholders paid more attention to those decisions made
by the chief, CEO, CFO and those relevant staffs, ENRON can avoid this result.

2.4 The consequences of Enron Collapse

Enron stands for the greatest company scandal in the history of the US economy and has
become a symbol of corruption for the whole Western economic system.

• Thousands employees lost their jobs.

• Investors lost some 60 billion dollars within a few days; for many it meant losing their old
age security.

• The pension fund for the company's employees was obliterated.

• Citizen’s trust in the American economic system was destroyed.

• Losses on the financial market amounted to the worst stock value loss in peaceful times.

• Banks were suspected of collusion.

• The auditing firm Arthur Anderson lost its accreditation.

• The rules for company financial reporting were drastically sharpened: Sarbanes-Oxley Act
(2002).

• The close ties of the company's founder, Kenneth Lay, to US President George W. Bush –
Lay was an important financial supporter of Bush – came under sharp criticism

Enron Scandal impacts on economy and Stock market

The Enron scandal was the largest corporate financial scandal ever when it emerged. It took the
economy the better part of a year to recover from the damage the Enron controversy caused to the
US as a whole. Enron is not fully responsible, but it was a large contributor to the collapse of the
stock market in the early 2000’s.as like-

In the year following the 9/11 hit to country’s economy the DOW lost close to 4500 points; down
to 7500 from almost 12000, it did gain some back, but considering the great depression was only a
decline of 2000 points or so, this is obviously a considerable impact on the economy. WorldCom
and Tyco, also contributing to the large impacts on the economy, followed the Enron scandal
abruptly. However, stock inflations such as these occurring across the entirety of the economy are
probably responsible for the sudden jump of the DOW over 10,000 points back in 1998. Corporate
fraud against investors and the government cannot continue. Practices as important and flexible as
accounting should be conducted hand in hand with moral and ethical codes and obligations.

The Enron scandal was the first of its kind, the largest chapter 11 bankruptcy in history. The
subsequent events following the bankruptcy will spotlight most of the corporate system. Since Enron

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went bankrupt everything from banks to brokers and auditors to analysts have been put on trial for
defrauding the entire US investment system.

At the time, Enron's collapse was the biggest corporate bankruptcy to ever hit the financial world.
The Enron scandal drew attention to accounting and corporate fraud as its shareholders lost $74
billion in the four years leading up to its bankruptcy, and its employees lost billions in pension
benefits.

There is also an indirect impact on Enron on Financial crisis 2007-2008, because after mass falling
in stock market due to this scandal, investors pull out their investment from stock market and they
became more interested in-house business investment which leads USA towards financial crisis
2007-08.
2.4.1 The Victim: Employees and Pension Fund Holders
The collapse of Enron has left thousands of people out of work. Thousands lost their personal
investments and pensions after the scandal broke out and Enron's stock plunged. Many employees
had personal pension funds made up of Enron shares - a common situation in America, where
occupational schemes based on final salary payments are increasingly rare and money purchase
schemes, known as 401(K) plans, are the norm. Employees at Enron were encouraged to do so by
the company, which also forbade them from selling their stocks, when the company share price
came down. In contrast, many Enron executives were able to cash in their share options when the
company’s fate became clear.
2.4.2 Creation of Sarbanes-Oxley Act, 2002
Between December 2001 and April 2002, the Senate Committee on Banking, Housing, and Urban
Affairs and the House Committee on Financial Services held multiple hearings about the Enron
scandal and related accounting and investor protection issues. These hearings and the corporate
scandals that followed Enron led to the passage of the Sarbanes-Oxley Act on July 30, 2002. The
Act is nearly "a mirror image of Enron: the company's perceived corporate governance failings are
matched virtually point for point in the principal provisions of the Act."
The main provisions of the Sarbanes-Oxley Act included the establishment of the Public Company
Accounting Oversight Board to develop standards for the preparation of audit reports; the restriction
of public accounting companies from providing any non-auditing services when auditing; provisions
for the independence of audit committee members, executives being required to sign off on financial
reports, and relinquishment of certain executives' bonuses in case of financial restatements; and
expanded financial disclosure of companies' relationships with unconsolidated entities. On February
13, 2002, due to the instances of corporate malfeasances and accounting violations, the SEC
recommended changes of the stock exchanges' regulations. In June 2002, the New York Stock
Exchange announced a new governance proposal, which was approved by the SEC in November
2003. The main provisions of the final NYSE proposal include:
 All companies must have a majority of independent directors.
 Independent directors must comply with an elaborate definition of independent directors.
 The compensation committee, nominating committee, and audit committee shall consist of
independent directors.
 All audit committee members should be financially literate. In addition, at least one member
of the audit committee is required to have accounting or related financial management
expertise.
 In addition to its regular sessions, the board should hold additional sessions without
management.

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2.5 Punishment
Kenneth Lay

 Born April 15, 1942

Tyrone, Missouri, USA

 Died July 5, 2006

 Conviction(s) fraud, false statement

 Penalty died before sentencing, conviction vacated

 Died of a heart attack before his sentencing

Jeffrey Skilling
 Born November 25, 1953

 Conviction(s) conspiracy, securities fraud, false statement, insider trading

 Penalty imprisoned 24 years and 4 months, fined $45 million

 Occupation prisoner/Failed Businessman

 Spouse Rebecca Carter

Andrew Fastow
 On October 31, 2002, Fastow was indicted by a federal grand jury in Houston, Texas
on 78 counts including fraud, money laundering, and conspiracy.
 On January 14, 2004, he pled guilty to two counts of wire and securities fraud, and
agreed to serve a ten-year prison sentence.
 He also agreed to become an informant and cooperate with federal authorities in the
prosecutions of other former Enron executives in order to receive a reduced sentence.
As of November 2006, Fastow is Inmate #14343-179 at the Federal Detention Center
(FDC) in Oakdale, Louisiana, with a projected release date of December 17, 2011

David Duncan
 Jan. 10, 2002: Arthur Andersen says its employees destroyed a "significant but
undetermined“ number of Enron documents
 David Duncan were cited as the responsible managers in this scandal as they had given
the order to shred relevant documents

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  On April 9, 2002 he pleaded guilty; the maximum sentence for his crimes is ten years,
but since he pleaded guilty and became a witness for the prosecution he would have
presumably received a much smaller sentence.
The final blows came when Andersen was banned from US government work after being
indicted by a federal grand jury on the charge of obstruction of justice. This was coupled with
the case brought by the US Department of Justice against the Andersen UK office for joining
in the shredding of Enron documents. This caused Andersen UK practices to reopen merger
talks with other accounting firms in response to these claims made against the office. Both
KPMG and Deloitte had been interested in Andersen's UK business, but KPMG's interest
trailed off as more information became available about Andersen's financial situation and the
potential risk of litigation. Andersen UK agreed to join with Deloitte, Touché & Tohmatsu. In
addition, Deloitte reached agreements with Andersen partners in Spain, Portugal, the US and
Mexico.

2.5.1 What Happened to Arthur Andersen?

In March 2002, the federal government indicted Arthur Andersen for obstruction of justice.
The indictment alleged that Arthur Andersen continued to shred documents and delete
computer files relating to its audit client, Enron, after it was aware that civil litigation and
government investigations were imminent and even after Enron had received an informal
request for information from the Securities and Exchange Commission. According to the
indictment, Arthur Andersen's destruction of Enron documents ceased only after it was served
with a subpoena from the SEC. Arthur Andersen claimed, among other responses, that
destruction of the Enron information was performed pursuant to Arthur Andersen's document
retention policy. On June 15, 2002, a jury convicted Arthur Andersen. (Interestingly, reports of
post-trial interviews with jurors indicate that the jurors did not focus on shredded or deleted
documents or computer files to convict the company. Rather, jurors said they based their
decision on a single e-mail from Arthur Andersen's in-house attorney to an Arthur Andersen
partner that suggested changes to language in a memorandum regarding an Enron press
release.) On October 16, 2002, Arthur Andersen received the maximum possible sentence with
a $500,000 fine and five years of probation.

2.5.2 From a "Big 5" to Collapse

By 2002, all of the trust and glory came tumbling down. That June, Andersen was convicted of
obstruction of justice for shredding documents related to its audit of Enron, resulting in what
infamously became known as the Enron scandal.
Even the Securities and Exchange Commission (SEC) did not emerge unscathed. Many accused the
oversight commission of being "asleep at the wheel." But aside from Enron, the up-until-then highly
reputable and respected Arthur Andersen stood the most to lose, and it did.
More faulty audits on behalf of Arthur Andersen were discovered in the course of the Enron
indictment and investigation. Big-name accounting scandals linked to Arthur Andersen went on to
include Waste Management, Sunbeam, and WorldCom.

2.6 What then is the Solution?

If there is any good that came from a situation like Enron, it’s that collectively as an investing public,
we are better versed on accounting fraud of this nature. The financial markets, the analysts, the
Securities and Exchange Commission, and the public accountants have all by now absorbed many
of the intricacies of SPE abuse. In short, we now know for what to look and efforts be focused
accordingly. So how do we prevent another Enron from happening again? The standard-setters and

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the gatekeepers, in spite of all the accounting and disclosure reform, need to appreciate with what
they are dealing. A deficiency or a perceived deficiency in the accounting rules is not the problem.
The problem is persons that seek to obfuscate, omit, and fraudulently report financial information.
Accordingly focus on ferreting out SPE abuse should be primarily placed on the abusers themselves,
not the SPEs formed to perpetrate such abuse. Wide spread legislation and accounting reform merely
casts a broad net with the hopes that the abusers will get snared along with the rest of the fish.
But in the meantime those fish are burdened with the added cost of complex and complicated
compliance when they weren’t doing anything wrong under the old regime nor had problems
complying under the old regime.
So what is the alternative? The forefront of the approach should be a narrow and isolated focus on
SPE abusers. Although the matter has not been completely resolved, the evidence suggests that
actual SPE abusers represent a small pool of companies relative to the total population of public
companies. This could be achieved by the SEC and or other related gatekeepers taking a “risk-based”
approach toward the problem. First, the gatekeepers should narrow its scope by first focusing on
those companies’ or industries that lend themselves or could potentially lend themselves toward
SPE abuse.
Those industries that tend to deal heavily in derivatives, intangible assets such as the buying and
selling of futures contracts, etc. would be good places to start. Additionally, those industries or
companies that stand to come under earnings pressure, i.e. having trouble reaching financial
forecasts or earnings targets, or seem to be engaging in creative ways at maintaining earnings and
revenue growth. The overarching idea is that since we have seen it before (ala Enron), that
accumulated knowledge is taken and applied going forward. It could very well be possible that in
terms of SPE abuse, the proprietary abuse that Enron perpetrated was a local and isolated event. The
SEC Report, though useful in the information it contained, did little to address the question of
whether or not there is widespread SPE and off-balance sheet abuse. The Report merely focused on
SPE and off-balance sheet use, which is helpful but doesn’t tell the whole story nor tell the most
important part of the story.
With all of this collective knowledge and insight as to the accounting fraud that Enron perpetrated,
it is reasonable to conclude that the SEC could derive some sort of search criteria or “corporate
profiling” of either industries or particular companies that show indicia for potential SPE abuse.
Those companies could then be targeted and special attention and focus could be placed on those
companies. Understand that the initial stages of such action would be non-intrusive. The initial
stages of the focus would merely involve a close and scrutinizing look at those companies’ annual
and periodic reports for evidence of SPE abuse or any other type of financial reporting irregularities.
If such scrutiny raises red flags then the SEC could then perform an escalated inquiry into the
matter. If the escalated inquiry yields problematic accounting, then the next step would be for the
SEC to initiate a more aggressive fact finding inquiry. If accounting irregularities are found, the
indictment, prosecution and ultimate conviction should be a high profile event. Such would then
send a clear and unequivocal message to other similarly situated offenders to make the proper
adjustments in their financial reporting or face the same fate.

2.7 Three lessons from Enron collapse

1. There are still several important lessons for investors to take from the Enron scandal. First, it's
critical not to have too much of your portfolio invested in a single stock. No matter how compelling
the company's story might be, the threat of a reversal that you could never predict can wipe you out
if you have too much of your money invested in it.

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2. Company employees should be especially cautious about buying their employer's stock. It's
tempting to invest in a business you know well, but if something goes wrong, you risk both losing
your primary source of income and taking a big hit in your investment portfolio at the same time.
3. make sure you understand how a company's business works. Most shareholders couldn't
understand Enron's sophisticated trading business, but they didn't really care as long as the stock
was moving higher. That left them completely vulnerable to changes in the fundamental health of
the business in which Enron was operating. Between the high levels of leverage, complicated
derivatives, and management that turned out to be questionable in its honesty and integrity, Enron
provided some warning signs to those willing to listen, and shareholders could have avoided some
of the damage from the scandal if they'd steered clear. Seventeen years after the energy company's
bankruptcy filing, the Enron scandal still has an influence on the investing world. By recognizing
that similar risks still exist today, you can remain vigilant and protect yourself from future scandals.

2.8 What is the Andersen Effect?

The Andersen Effect is a reference to auditors performing even more due diligence than previously
required in order to prevent the kinds of financial accounting errors and mishaps that precipitated
Enron's collapse in 2001.The Andersen Effect gets its name from former Chicago-based accounting
firm Arthur Andersen LLP. By 2001, Arthur Andersen had grown into one of the Big 5 accounting
firms, joining the likes of PricewaterhouseCoopers, Deloitte Touche Tohmatsu, Ernst & Young, and
KPMG. At its peak, Arthur Andersen employed nearly 28,000 people in the U.S., and 85,000
worldwide. The firm was known globally for its ability to deploy experts internationally to advise
multinational businesses across its auditing, tax, and consulting practices.
2.9 Conclusion
The issues dealt with in this paper are complex and trying to resolve these issues pose an even
greater challenge. But before real effective change can be achieved, we must first be able to
target the root of the problem. Complex problems tend to involve complex solutions. The Band-
Aid of legislation, more guidance, or “clearer” guidance if you will, will more than likely result
in nothing more than the tug and pull between standard-setters and issuers to continue along
this “move”, “countermove” approach that has gotten us to where we are today. Until we are
able to focus more narrowly on the problem and deal with it from that more directed approach,
we’ll probably be seeing more of the same. Better mousetrap, better mouse.

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 Chapter: 03 Solution of the Case Questions
3.1 Questions & Solutions of Case 1.1 Enron Corporation:

Q#1. The Enron debacle created what one public official reported was a “crisis of
confidence” on the part of the public in the accounting profession. List the parties who
you believe are the most responsible for that crisis. Briefly justify each of your choices.

Solution:
Executives of Enron - Kenneth Lay, Jeffery Skilling, and Andrew Fastow were all responsible
for the crisis. The executives of Enron orchestrated the big earnings and pushed up the stock
prices for their own benefit. When misstatements and irregularities emerged and were made
clear to the public, the executives of Enron lost the confidence of the stakeholders in the
company and the crisis of confidence spread.

Arthur Andersen - The auditing firm did not present itself with the professionalism and
responsibility that an audit firm should. When the firm noticed that the amounts recorded on
Enron’s financial statements were misstated, it was ignored in order to continue receiving the
enormous amounts of fees and payments from the corporation. In doing so, the confidence that
the public had in the company was diminished.

SEC - The government agency who allowed Enron to use Mark-to-Market Accounting practice.
This kind of creative accounting practice allowed the Enron CEO to perform his Ponzi scheme
“legally” and led to the sudden collapse of Enron.

Q#2. List three types of consulting services that audit firms have provided to their audit
clients in recent years. For each item, indicate the specific threats, if any, that the
provision of the given service can pose for an audit form’s independence.

Solution:
“Internal Auditing” should be conducted within a company instead of having an outside audit
firm to perform the service. If an outside audit firm was hired then it will present a threat to the
legitimacy of the internal audits.

An audit firm should not be “Designing Accounting Systems” for a firm while performing audit
services to the same firm. It is too easy for the audit firm to alter the accounting systems within
a company, an auditor can fabricate the financial situations of a corporation and make it appears
to be more profitable or more attractive to investors.

An outside audit firm should not provide “Professional Consulting” and auditing service to a
same company. Auditors involved in the dealings of a business are at risk for becoming
subjective to the success of that organization. When an auditor is involved in such happenings,
they are not able to perform their duties as an external auditor to the best of their ability. Their
opinions are subject to change based on biases.

Q#3. For purposes of the question, assume that the excerpts from the Powers Report
provide accurate descriptions of Andersen’s involvement in Enron’s accounting and

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financial reporting decisions. Given this assumption, do you believe that Andersen’s
involvement in those decisions violated any professional auditing standards? If so, list
those standards and briefly explain your rationale.

Solution:
Yes, Andersen’s involvement in the accounting and financial reporting decisions violated
professional auditing standards of the independence in mental attitude. Andersen’s interests
were not independent of the company, but the audit firm invested themselves in solidifying the
security of the company and its success.

The significant amount of earnings that Andersen received when performing accounting
services to Enron goes against auditing standards.

Q#4. Briefly describe the key requirements included in professional auditing standards
regarding the preparation and retention of audit workpapers. Which party “owns” audit
workpapers: the client or the audit firm?

Solution:
The key requirements included in professional auditing standards regarding the preparation and
retention of audit workpapers are:

i) The auditor must state in the auditor’s report whether the financial statements are presented
in accordance with GAAP.

ii) The auditor must bring to light an instances in which the GAAP were not consistent during
the current period.

iii) When informative disclosures are not adequate, the auditor must state so in the report.

iv) The auditor must state an opinion in regards to the financial statements. If the auditor cannot
state an opinion, this much be noted in the report. If the auditor is taking any responsibility
in relation to the financial statements, it must also be stated in the auditor’s report.

The audit workpapers belong to auditing firm. The auditor does hold responsibility for the
evidence and reports, and is to make sure that the information is not misused in any way.
Q#5. Identify and list five recommendations that have been made recently to strengthen
the independent audit function. For each of these recommendations, indicate why you
support or do not support the given measure.

Solution:
i) Revise the rules related to the non-audit services that, if provided to an audit client,
would impair an accounting firm's independence.

Support; independence is the key in performing an audit.

ii) Require the auditor to report certain matters to the issuer's audit committee, including
"critical" accounting policies used by the issuer.

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Support; in many cases, the internal auditors need to have access to the information that external
audit firms happen upon.

iii) Require the issuer's audit committee to pre-approve all audit and non-audit services
provided to the issuer by the auditor.

Support; the audit committee should know beforehand what the auditor will be providing for
the company.

iv) Require disclosures to investors of information related to audit and non-audit services
provided by, and fees paid to, the auditor.

Support; the cost of audit should be disclosed. An abnormal high audit fees is also an indicator
of “something doesn’t smell right”.

v) Establish rules that an accounting firm would not be independent if certain members of
management of that issuer had been members of the accounting firm's audit engagement team
within the one-year period preceding the commencement of audit procedures.

Support; this allows the accounting and auditing teams to remain separate in their powers.

Q#6. Do you believe that there has been a significant shift or evolution over the past
several decades in the concept of “professionalism” as it relates to the public accounting
discipline? If so, explain how you believe that concept has changed or evolved over that
time frame and identify the key factors responsible for any apparent changes.

Solution:
Yes, I believe that there has been a significant shift over the past several decades, in which it
has occurred towards a standpoint via setting up standards and regulations which allows
accountants and auditors to be more accountable for their work. Key factors in this evolution
are laws, regulations, and the implantation of GAAP and GAAS.
Q#7. As pointed out in this case, the SEC does not require public companies to have their
quarterly financial statements audited. What responsibilities, if any, do audit firms have
with regard to the quarterly financial statements of their clients? In your opinion, should
quarterly financial statements be audited? Defend your answer.

Solution:
I believe that it is the responsibility of an auditor to examine quarterly statements during a
yearly audit. An auditor should always be skepticism when performing audit service to any
client. If an audit was done quarterly on a company opposed to yearly, and misstatements and
fabrications would appear sooner to an audit firm.

3.2 Conclusion
Fraudulent accounting techniques allowed Enron to be listed as the seventh largest company in
the United States and it was expected to dominate the trading it had virtually invented in
communications, power, and weather securities. Instead, it became the largest corporate

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scandal in history, and became emblematic of institutionalized and well-planned corporate
fraud. After a series of scandals involving irregular accounting procedures bordering on fraud
involving Enron and its accounting firm Arthur Andersen, it stood at the verge of undergoing
the largest bankruptcy in history. During 2001, Enron shares fell from US$85 to US$0.30. As
Enron was considered a blue chip stock, this was an unprecedented and disastrous event in the
financial world. Enron's plunge occurred after it was revealed that many of its profits and
revenue were the result of deals with special purpose entities. The Enron scandal is extremely
rich in lessons. The most important lesson is the understanding that the fraudulent accounting
was not the cause of the scandal, but the consequence of how Enron was governed. In other
words, the root of the problem was not the accounting manipulation, which has just been a
consequence of collective failures by a wide range of internal and external agents. The Enron
case should be viewed as an opportunity to prevent other ill governed companies from causing
similar losses to investors and society.

References
Andersen (Arthur) & Co. http://www.encyclopedia.chicagohistory.org/pages/2547.html
Accessed: 2023-05-04

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BBC News | Enron: The rise and fall
http://news.bbc.co.uk/hi/english/static/in_depth/business/2002/enron/timeline/default.stm
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