Case 1.1 – Enron Corporation

The auditor has the responsibility to evaluate the risk of material fraud, including:  Incentives and motives for fraud : Enron was a fast growing company with many start-ups projects, such as the Energy Wholesale Services (a B2B electronic marketplace for the energy industries) or the Enron Broadband Services (an operating unit serving as intermediary between users and suppliers of broadband services,) that constantly needed huge amount of money to succeed.  The opportunity to commit fraud: Enron internal controls were weak and the management was promoting a culture that encouraged fraud rather than honesty. Rationalizations that might allow someone to commit fraud: the management at Enron believed that they were only trying to grow the company and increase their stock price by misrepresenting their financial statements. Once their new ventures would succeed, they would be able to cover the losses previously incurred. All the ingredients were present for Anderson to uncover the fraud. Moreover, the auditors have a responsibility to disclose material fraud and illegal client acts to the audit committee and the Board of Directors.

If the financial statements are not restated, the auditor should issue a qualified, an adverse opinion or consider withdrawing from the engagement. The team auditing Enron should have followed the guidance when the management acted with scienter. As mentioned in the case, Arthur Andersen was being paid exorbitant amounts of money to audit Enron and attest to the validity of its financial statements. The firm failed on every front to catch any of the fraudulent accounting transpiring and many critics questioned whether Anderson was involved with “cooking the books”.

Given the scale of the compensation and how entrenched the firm was in Enron’s financial operations, it is hard to believe that the Andersen auditors, CPAs, failed to notice such obviously illegal accounting treatments of transactions. As so well said by the auditor of Accounting Today, “if a firm accepts and collects the audit fee, then it should be prepared to accept the blame, otherwise it is not part of the solution, but part of the problem”. The fault not only goes to the auditors, but to the company’s management as well.

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Enron’s management Kenneth Lay turned a blind eye to anything that could obstruct Enron’s growth. He said that his ultimate goal was to make Enron “the world’s greatest company. ” This is a great goal for any CEO to have; however, in his attempts to reach this goal, he developed a case of tunnel vision that led to unexpected consequences. When Sherron Watkins wrote him a letter questioning the treatment of certain accounting transactions and puzzled disclosures, he ignored her and stated that “he’d rather not see it”.

Kenneth Lay even failed to acknowledge or address the issues after most of the Enron scandal had fully unraveled by refusing to testify before Congress in 2002. Jeffrey Skilling basically followed in the footsteps of Kenneth Lay and brought with him a similar approach to running a business. Skilling shared the same tunnel vision approach as Lay as evidenced by their “laser-focus on earnings per share”. They both were willing to ignore any wrongdoing in the company as long as earnings per share continued to increase.

Skilling also developed a certain level of arrogance after being singled out as the number one CEO in the country. He would make “brassy and tacky” comments regarding Enron’s competitors and critics. This arrogance likely aided in his ability to shield out the negative aspects of Enron’s operations and to only see the positives. He was the “best CEO in America”, so Enron couldn’t possibly do anything terribly wrong under his watch. When being questioned by Congressional investigators regarding the scandal, he simply passed the blame by stating that “he is not an accountant. Andrew Fastow was the CFO and created the financial infrastructure for Enron. He, like Skilling, was hailed as one of the top executives in the country as evidenced by his Excellence in Capital Structure Management award presented to him by CFO Magazine. As the CFO of Enron, Fastow should have known better than to do what he did with the creation and operation of the SPEs. His brass was at such a high level that he even named several of them after his children.

He, like Kenneth Lay, refused to take any accountability by refusing to testify before Congress in 2002. SEC and FASB The SEC and FASB also share the responsibility for the fraud scandal that took place. The organisms should have passed stronger accounting standards to regulate auditing. Both organizations were in favor of the 3% rule for SPEs. This rule stated that a SPE needed only a 3% investment from an outside investor to be considered independent. This rule allowed Enron to discharge all its unprofitable businesses in SPEs to avoid consolidating losses.

That is, the SEC and FASB endorsed a law that allowed companies to dump considerable losses in off-balance entities. A case of fraud was bound to happen. The Auditors, the SEC, and the FASB made it easy for Enron’s management to commit one of the biggest frauds in the history of accounting.

Discussion

Andersen’s involvement in Enron’s accounting and financial reporting decisions violated the following professional auditing standards: AU 220, Independence, SAS 1) – this standard requires the auditor to be independent. Auditors issue an audit opinion that will serve as a reliable source of information on the company to external parties (investors). Thus, it is necessary for the auditor to be unbiased when reporting his findings to the public. The lack of independence of the team auditing Enron can be derived from the fact that Andersen was providing consulting services as well as auditing services to Enron, with consulting work accounting for more than 50% of the total yearly revenue received from Enron.

This situation led Andersen to be at the same time external auditor and internal auditor to Enron. AU 316, Consideration of Fraud in a Financial Statement Audit (SAS 99) – this standard concerns “fraudulent acts that cause a material misstatement of the financial statements. ” Andersen helped Enron misrepresent significant information in the financial statements. The team auditing Enron intentional misapplied accounting principles relating to the classification, the manner of presentation, and the disclosure of the financial statements. To clarify, Enron would use the mark-to-market ccounting method on long-term accounting contract, which immediately recognizes earnings when contracts are secured rather than when services are rendered. That accounting method results in financial statements being materially misstated and at the same time, it considerably increased the compensation of Executives at Enron that was based on earnings. AU 317. 05, Illegal Acts by Clients (SAS 54) – this standard indicates that the auditor’s responsibility for misstatements resulting from “illegal acts having a direct and material effect on the determination of financial statement amounts” is the same as that for errors or fraud.

Enron would issue stocks to different SPEs in exchange for notes receivable; however, US GAAP does not allow for the recording of receivables in exchange of stocks issued. These misstatements led to a reduction of $1. 2 billion in Owners’ Equity after the reversal of previously recorded transactions as assets. In addition, Enron had investments in companies (not SPEs) that it consolidated, but when the investments began to show losses, they were transferred to SPEs so that it would not have to reflect these losses on the financial statements.

AU 334, Related Party Transactions, SAS 45 – this standard requires auditors to follow GAAS established procedures when auditing financial statements in order “to identify related party relationships and transactions” and to estimate whether or not the required financial statement accounting and disclosure had been followed. This standard was also violated as Executives of Enron were managing some SPEs (p. 13. ) Andrew Fastow, Enron’s CFO, earned a profit amounting to $30 million on one of his investment in an SPE that he was managing.

Furthermore, “Fastow’s friends realized a profit $1 million on investment of $5,800 in 60 days in the same SPE. ” AU 319, Consideration of Internal Controls in a Financial Statement audits – The auditor’s report on internal control over financial reporting that goes to the public must report material weaknesses in internal control. Andersen audit team in charge of Enron auditing failed to provide an unbiased opinion on the effectiveness of the system of internal control over financial reporting.

After Enron and other fraud scandals, we see a shift from the self-oversight of public accounting firms to an independent oversight of accounting firms auditing public companies by government bodies such as the PCAOB. Congress passed the Sarbanes-Oxley Act (SOX) in 2002 which goal was to strengthen the financial reporting rules for public companies. It also forced public companies to prepare reports on the quality of their internal controls as well as limit the types of consulting services that an accounting firm is allowed to provide to its clients in concurrence with audit services provided.

Fraud scandals also led to the establishment of the regulation requiring management of public companies to provide a letter asserting that the financial statements are fairly stated. Most recently, the SEC voted to adopt whistleblower rules mandated by Section 922 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act). “The rules implement the Act’s requirement that the Commission pay an award to whistleblowers who voluntarily provide original information to the SEC that leads to a successful enforcement action with sanctions of over $1 million. Professionalism in public accounting has changed over the past decades for a variety of reasons from the advances in technology to the globalization of the economy. One of the ways professionalism has changed is that independence has become a major component for public accountants. Independence confirmations before the audit and during the audit are major parts of being professional in today’s definition. Ethics are another major part of professionalism. Being ethical in your decisions is stressed more now than ever before. Being courteous of others cultures, beliefs, and religions are a new addition to being professional.

With everything becoming global and information quickly being spread by technology, being conscientious of what is said and done is very important for accountants for one bad thing can have severe implications. Being professional is more than just how you act in the business place for since you represent the company, your actions are watched on and off the job. With the increasing numbers of investors in the market it becomes more pressing to have reforms to regulate the circulation of information and assure investors that they are using the highest quality of financial statements.

The SEC has required public companies to have their quarterly financial statements audited before filing of theirs quarterly report on Form 10-Q. Therefore, audit firms will need to follow all the audit standards set out, from establishing an understanding with the client to performing analytical procedures, inquiries and other review procedures to prepare an audit report on the review of interim financial information. It is our opinion that quarterly financial statements should be audited because they will be more reliable and credible to the investors.

Auditing quarterly financial statements will also shade lights on questionable management’s earnings. At the same time, a continuous (quarterly) audit will allow for less restatement at the end of the year; that is less surprise for investors. The auditor will be required to follow the clients’ financial situation more closely and address any material issues sooner. Quarterly audited financial statements will give investors confidence in relying on the company’s financial information.

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