The assignment is about auditing the Enron Corporation case with a group. I have been assigned to complete question 3 which you can view in the attachment provided. I also attached the entire Enron Corporation case for you to view. Can you please answer question 3 in both a summarization via word & power point format with the key details?
Thank you in advance!
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Chapter : Knapp Cases Enron Corporation
Book Title: Auditing: A Risk-Based Approach
Printed By: Angel Oliva (Angel.Oliva004@mymdc.net)
© 2019 Cengage Learning, Cengage Learning
Enron Corporation
Enron Corporation
John and Mary Andersen immigrated to the United States from their native Norway in 1881.
The young couple made their way to the small farming community of Plano, Illinois, some 40
miles southwest of downtown Chicago. Over the previous few decades, hundreds of
Norwegian families had settled in Plano and surrounding communities. In fact, the aptly
named Norway, Illinois, was located just a few miles away from the couple’s new hometown.
In 1885, Arthur Edward Andersen was born. From an early age, the Andersens’ son had a
fascination with numbers. Little did his parents realize that Arthur’s interest in numbers
would become the driving force in his life. Less than one century after he was born, an
accounting firm bearing Arthur Andersen’s name would become the world’s largest
professional services organization with more than 1,000 partners and operations in dozens
of countries scattered across the globe.
Think Straight, Talk Straight
Discipline, honesty, and a strong work ethic were three key traits that John and Mary
Andersen instilled in their son. The Andersens also constantly impressed upon him the
importance of obtaining an education. Unfortunately, Arthur’s parents did not survive to help
him achieve that goal. Orphaned by the time he was a young teenager, Andersen was
forced to take a full-time job as a mail clerk and attend night classes to work his way through
high school. After graduating from high school, Andersen attended the University of Illinois
while working as an accountant for Allis-Chalmers, a Chicago-based company that
manufactured tractors and other farming equipment. In 1908, Andersen accepted a position
with the Chicago office of Price Waterhouse. At the time, Price Waterhouse, which was
organized in Great Britain during the early nineteenth century, easily qualified as the United
States’ most prominent public accounting firm.
At age 23, Andersen became the youngest CPA in the state of Illinois. A few years later,
Andersen and a friend, Clarence Delany, established a partnership to provide accounting,
auditing, and related services. The two young accountants named their firm Andersen,
Delany & Company. When Delany decided to go his own way, Andersen renamed the firm
Arthur Andersen & Company.
In 1915, Arthur Andersen faced a dilemma that would help shape the remainder of his
professional life. One of his audit clients was a freight company that owned and operated
several steam freighters that delivered various commodities to ports located on Lake
Michigan. Following the close of the company’s fiscal year but before Andersen had issued
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his audit report on its financial statements, one of the client’s ships sank in Lake Michigan.
At the time, there were few formal rules for companies to follow in preparing their annual
financial statements and certainly no rule that required the company to report a material
“subsequent event” occurring after the close of its fiscal year—such as the loss of a major
asset. Nevertheless, Andersen insisted that his client disclose the loss of the ship. Andersen
reasoned that third parties who would use the company’s financial statements, among them
the company’s banker, would want to be informed of the loss. Although unhappy with
Andersen’s position, the client eventually acquiesced and reported the loss in the footnotes
to its financial statements.
Two decades after the steamship dilemma, Arthur Andersen faced a similar situation with an
audit client that was much larger, much more prominent, and much more profitable for his
firm. Arthur Andersen & Co. served as the independent auditor for the giant chemical
company DuPont. As the company’s audit neared completion one year, members of the
audit engagement team and executives of DuPont quarreled over how to define the
company’s operating income. DuPont’s management insisted on a liberal definition of
operating income that included income earned on certain investments. Arthur Andersen was
brought in to arbitrate the dispute. When he sided with his subordinates, DuPont’s
management team dismissed the firm and hired another auditor.
Throughout his professional career, Arthur E. Andersen relied on a simple, four-word motto
to serve as a guiding principle in making important personal and professional decisions:
“Think straight, talk straight.” Andersen insisted that his partners and other personnel in his
firm invoke that simple rule when dealing with clients, potential clients, bankers, regulatory
authorities, and any other parties they interacted with while representing Arthur Andersen &
Co. He also insisted that audit clients “talk straight” in their financial statements. Former
colleagues and associates often described Andersen as opinionated, stubborn, and, in
some cases, “difficult.” But even his critics readily admitted that Andersen was point-blank
honest. “Arthur Andersen wouldn’t put up with anything that wasn’t complete, 100% integrity.
If anybody did anything otherwise, he’d fire them. And if clients wanted to do something he
didn’t agree with, he’d either try to change them or quit.”
As a young professional attempting to grow his firm, Arthur Andersen quickly recognized the
importance of carving out a niche in the rapidly developing accounting services industry.
Andersen realized that the nation’s bustling economy of the 1920s depended heavily on
companies involved in the production and distribution of energy. As the economy grew,
Andersen knew there would be a steadily increasing need for electricity, oil and gas, and
other energy resources. So he focused his practice development efforts on obtaining clients
involved in the various energy industries. Andersen was particularly successful in recruiting
electric utilities as clients. By the early 1930s, Arthur Andersen & Co. had a thriving practice
in the upper Midwest and was among the leading regional accounting firms in the nation.
The U.S. economy’s precipitous downturn during the Great Depression of the 1930s posed
huge financial problems for many of Arthur Andersen & Co.’s audit clients in the electric
utilities industry. As the Depression wore on, Arthur Andersen personally worked with
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several of the nation’s largest metropolitan banks to help his clients obtain the financing they
desperately needed to continue operating. The bankers and other leading financiers who
dealt with Arthur Andersen quickly learned of his commitment to honesty and proper,
forthright accounting and financial reporting practices. Andersen’s reputation for honesty
and integrity allowed lenders to use with confidence financial data stamped with his
approval. The end result was that many troubled firms received the financing they needed to
survive the harrowing days of the 1930s. In turn, the respect that Arthur Andersen earned
among leading financial executives nationwide resulted in Arthur Andersen & Co. receiving
a growing number of referrals for potential clients located outside of the Midwest.
During the later years of his career, Arthur Andersen became a spokesperson for his
discipline. He authored numerous books and presented speeches throughout the nation
regarding the need for rigorous accounting, auditing, and ethical standards for the emerging
public accounting profession. Andersen continually urged his fellow accountants to adopt
the public service ideal that had long served as the underlying premise of the more mature
professions such as law and medicine. He also lobbied for the adoption of a mandatory
continuing professional education (CPE) requirement. Andersen realized that CPAs needed
CPE to stay abreast of developments in the business world that had significant implications
for accounting and financial reporting practices. In fact, Arthur Andersen & Co. made CPE
mandatory for its employees long before state boards of accountancy adopted such a
requirement.
By the mid-1940s, Arthur Andersen & Co. had offices scattered across the eastern one-half
of the United States and employed more than 1,000 accountants. When Arthur Andersen
died in 1947, many business leaders expected that the firm would disband without its
founder, who had single-handedly managed its operations over the previous four decades.
But, after several months of internal turmoil and dissension, the firm’s remaining partners
chose Andersen’s most trusted associate and protégé to replace him.
Like his predecessor and close friend who had personally hired him in 1928, Leonard
Spacek soon earned a reputation as a no-nonsense professional—an auditor’s auditor. He
passionately believed that the primary role of independent auditors was to ensure that their
clients reported fully and honestly regarding their financial affairs to the investing and
lending public.
Spacek continued Arthur Andersen’s campaign to improve accounting and auditing practices
in the United States during his long tenure as his firm’s chief executive. “Spacek openly
criticized the profession for tolerating what he considered a sloppy patchwork of accounting
standards that left the investing public no way to compare the financial performance of
different companies.”
Such criticism compelled the accounting profession to develop a
more formal and rigorous rule-making process. In the late 1950s, the profession created the
Accounting Principles Board (APB) to study contentious accounting issues and develop
appropriate new standards. The APB was replaced in 1973 by the Financial Accounting
Standards Board (FASB).
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Another legacy of Arthur Andersen that Leonard Spacek sustained was requiring the firm’s
professional employees to continue their education throughout their careers. During
Spacek’s tenure, Arthur Andersen & Co. established the world’s largest private university,
the Arthur Andersen & Co. Center for Professional Education located in St. Charles, Illinois,
not far from Arthur Andersen’s birthplace.
Leonard Spacek’s strong leadership and business skills transformed Arthur Andersen & Co.
into a major international accounting firm. When Spacek retired in 1973, Arthur Andersen &
Co. was arguably the most respected accounting firm not only in the United States, but
worldwide as well. Three decades later, shortly after the dawn of the new millennium, Arthur
Andersen & Co. employed more than 80,000 professionals, had practice offices in more
than 80 countries, and had annual revenues approaching $10 billion. However, in late 2001,
the firm, which by that time had adopted the one-word name “Andersen,” faced the most
significant crisis in its history since the death of its founder. Ironically, that crisis stemmed
from Andersen’s audits of an energy company, a company founded in 1930 that, like many
of Arthur Andersen’s clients, had struggled to survive the Depression.
The World’s Greatest Company
Northern Natural Gas Company was founded in Omaha, Nebraska, in 1930. The principal
investors in the new venture included a Texas-based company, Lone Star Gas Corporation.
During its first few years of existence, Northern wrestled with the problem of persuading
consumers to use natural gas to heat their homes. Concern produced by several
unfortunate and widely publicized home “explosions” caused by natural gas leaks drove
away many of Northern’s potential customers. But, as the Depression wore on, the relatively
cheap cost of natural gas convinced increasing numbers of cold-stricken and shallowpocketed consumers to become Northern customers.
The availability of a virtually unlimited source of cheap manual labor during the 1930s
allowed Northern to develop an extensive pipeline network to deliver natural gas to the
residential and industrial markets that it served in the Great Plains states. As the company’s
revenues and profits grew, Northern’s management launched a campaign to acquire dozens
of its smaller competitors. This campaign was prompted by management’s goal of making
Northern the largest natural gas supplier in the United States. In 1947, the company, which
was still relatively unknown outside of its geographical market, reached a major milestone
when its stock was listed on the New York Stock Exchange. That listing provided the
company with greater access to the nation’s capital markets and the financing needed to
continue its growth-through-acquisition strategy over the following two decades.
During the 1970s, Northern became a principal investor in the development of the Alaskan
pipeline. 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
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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.
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. In the
management letter to shareholders included in Enron’s 2000 annual report, Lay and Skilling
explained the metamorphosis that Enron had undergone over the previous 15 years:
Enron hardly resembles the company we were in the early days. During our 15-year
history, we have stretched ourselves beyond our own expectations. We have
metamorphosed from an asset-based pipeline and power generating company to a
marketing and logistics company whose biggest assets are its well-established
business approach and its innovative people.
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 market-place 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 ecommerce company in the world. Enron’s three other principal lines of business included
Enron Energy Services, the company’s retail operating unit; Enron Transportation Services,
which was responsible for the company’s pipeline operations; and Enron Broadband
Services, a new operating unit intended to be an intermediary between users and suppliers
of broadband (Internet access) services. Exhibit 1 presents the five-year financial highlights
table included in Enron’s 2000 annual report.
Exhibit 1
Enron Corporation 2000 Annual Report Financial Highlights Table (in Millions
Except for Per Share Amounts)
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2000
Revenues
1999
1998
1997
1996
$100,789 $40,112 $31,260 $20,273 $13,289
Net Income:
Operating Results
1,266
957
698
515
493
Items Impacting
(287)
(64)
5
(410)
91
979
893
703
105
584
Operating Results
1.47
1.18
1.00
.87
.91
Items Impacting
(.35)
(.08)
.01
(.71)
.17
Total
1.12
1.10
1.01
.16
1.08
Dividends Per Share:
.50
.50
.48
.46
.43
Total Assets:
65,503
33,381
29,350
22,552
16,137
Cash from Operating
3,010
2,228
1,873
276
742
3,314
3,085
3,564
2,092
1,483
High
90.56
44.88
29.38
22.56
23.75
Low
41.38
28.75
19.06
17.50
17.31
Close, December 31
83.12
44.38
28.53
20.78
21.56
Comparability
Total
Earnings Per Share:
Comparability
Activities:
Capital Expenditures
and Equity
Investments:
NYSE Price Range:
The New Economy business model that Enron pioneered for the previously staid energy
industries caused Kenneth Lay, Jeffrey Skilling, and their top subordinates to be recognized
as skillful entrepreneurs and to gain superstar status in the business world. 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 2001, Lay served on the “transition team” responsible
for helping usher in the administration of President-elect George W. Bush. In June 2001,
Skilling was singled out as “the No. 1 CEO in the entire country,” while Enron was hailed as
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“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.”
Throughout their tenure with Enron, Kenneth Lay and Jeffrey Skilling continually focused on
enhancing their company’s operating results. In the letter to shareholders in Enron’s 2000
annual report, Lay and Skilling noted that “Enron is laser-focused on earnings per share,
and we expect to continue strong earnings performance.” Another important goal of Enron’s
top executives was increasing their company’s stature in the business world. During a
speech in January 2001, Lay revealed that his ultimate goal was for Enron to become “the
world’s greatest company.”
As Enron’s revenues and profits swelled, its top executives were often guilty of a certain
degree of chutzpah. In particular, Skilling became known for making brassy, if not tacky,
comments concerning his firm’s competitors and critics. During the crisis that gripped
California’s electric utility industry during 2001, numerous elected officials and corporate
executives criticized Enron for allegedly profiteering by selling electricity at inflated prices to
the Golden State. Skilling brushed aside such criticism. During a speech at a major
business convention, Skilling asked the crowd if they knew the difference between the state
of California and the Titanic. After an appropriate pause, Skilling provided the punch line: “At
least when the Titanic went down, the lights were on.”
Unfortunately for Lay, Skilling, Fastow, and thousands of Enron employees and
stockholders, Lay failed to achieve his goal of creating the world’s greatest company. In a
matter of months during 2001, Enron quickly unraveled. Enron’s sudden collapse panicked
investors nationwide, leading to what one Newsweek columnist described as the “the
biggest crisis investors have had since 1929.”
Enron’s dire financial problems were
triggered by public revelations of questionable accounting and financial reporting decisions
made by the company’s accountants. Those decisions had been reviewed, analyzed, and
apparently approved by Andersen, the company’s independent audit firm.
Debits, Credits, and Enron
Throughout 2001, Enron’s stock price drifted lower. Publicly, Enron executives blamed the
company’s slumping stock price on falling natural gas prices, concerns regarding the longrange potential of electronic marketplaces such as EnronOnline, and overall weakness in
the national economy. By mid-October, the stock price had fallen into the mid-$30s from a
high in the lower $80s earlier in the year.
On October 16, 2001, Enron issued its quarterly earnings report for the third quarter of
2001. That report revealed that the firm had suffered a huge loss during the quarter. Even
more problematic to many financial analysts was a mysterious $1.2 billion reduction in
Enron’s owners’ equity and assets that was disclosed seemingly as an afterthought in the
earnings press release. This write-down resulted from the reversal of previously recorded
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transactions involving the swap of Enron stock for notes receivable. Enron had acquired the
notes receivable from related third parties who had invested in limited partnerships
organized and sponsored by the company. After studying those transactions in more depth,
Enron’s accounting staff and its Andersen auditors concluded that the notes receivable
should not have been reported in the assets section of the company’s balance sheet but
rather as a reduction of owners’ equity.
The October 16, 2001, press release sent Enron’s stock price into a free fall. Three weeks
later on November 8, Enron restated its reported earnings for the previous five years, wiping
out approximately $600 million of profits the company had reported over that time frame.
That restatement proved to be the death knell for Enron. On December 2, 2001, intense
pressure from creditors, pending and threatened litigation against the company and its
officers, and investigations initiated by law enforcement authorities forced Enron to file for
bankruptcy. Instead of becoming the nation’s greatest company, Enron instead laid claim to
being the largest corporate bankruptcy in U.S. history, imposing more than $60 billion of
losses on its stockholders alone. Enron’s “claim to fame” would be eclipsed the following
year by the more than $100 billion of losses produced when another Andersen client,
WorldCom, filed for bankruptcy.
The massive and understandable public outcry over Enron’s implosion during the fall of
2001 spawned a mad frenzy on the part of the print and electronic media to determine how
the nation’s seventh-largest public company, a company that had posted impressive and
steadily rising profits over the previous few years, could crumple into insolvency in a matter
of months. From the early days of this public drama, skeptics in the financial community
charged that Enron’s balance sheet and earnings restatements in the fall of 2001
demonstrated that the company’s exceptional financial performance during the late 1990s
and 2000 had been a charade, a hoax orchestrated by the company’s management with the
help of a squad of creative accountants. Any doubt regarding the validity of that theory was
wiped away—at least in the minds of most members of the press and the general public—
when a letter that an Enron accountant sent to Kenneth Lay in August 2001 was discovered.
The contents of that letter were posted on numerous websites and lengthy quotes taken
from it appeared in virtually every major newspaper in the nation.
Exhibit 2 contains key excerpts from the letter that Sherron Watkins wrote to Kenneth Lay in
August 2001. Watkins’ job title was vice president of corporate development, but she was an
accountant by training, having worked previously with Andersen, Enron’s audit firm. The
sudden and unexpected resignation of Jeffrey Skilling as Enron’s CEO after serving in that
capacity for only six months had prompted Watkins to write the letter to Lay. Before
communicating her concerns to Lay, Watkins had attempted to discuss those issues with
one of Lay’s senior subordinates. When Watkins offered to show that individual a document
that identified significant problems in accounting decisions made previously by Enron,
Watkins reported that he rebuffed her. “He said he’d rather not see it.”
Exhibit 2
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Selected Excerpts from Sherron Watkins’ August 2001 Letter to Kenneth Lay
Dear Mr. Lay,
Has Enron become a risky place to work? For those of us who didn’t get rich over
the last few years, can we afford to stay?
Skilling’s abrupt departure will raise suspicions of accounting improprieties and
valuation issues. Enron has been very aggressive in its accounting—most notably
the Raptor transactions and the Condor vehicle. . . .
We have recognized over $550 million of fair value gains on stocks via our swaps
with Raptor, much of that stock has declined significantly. . . . The value in the
swaps won’t be there for Raptor, so once again Enron will issue stock to offset these
losses. Raptor is an LJM entity. It sure looks to the layman on the street that we are
hiding losses in a related company and will compensate that company with Enron
stock in the future.
I am incredibly nervous that we will implode in a wave of scandals. My 8 years of
Enron work history will be worth nothing on my resume, the business world will
consider the past successes as nothing but an elaborate accounting hoax. Skilling is
resigning now for “personal reasons” but I think he wasn’t having fun, looked down
the road and knew this stuff was unfixable and would rather abandon ship now than
resign in shame in 2 years.
Is there a way our accounting gurus can unwind these deals now? I have thought
and thought about how to do this, but I keep bumping into one big problem—we
booked the Condor and Raptor deals in 1999 and 2000, we enjoyed a wonderfully
high stock price, many executives sold stock, we then try and reverse or fix the
deals in 2001 and it’s a bit like robbing the bank in one year and trying to pay it back
2 years later. . . .
I realize that we have had a lot of smart people looking at this and a lot of
accountants including AA & Co. have blessed the accounting treatment. None of this
will protect Enron if these transactions are ever disclosed in the bright light of day. . .
.
The overriding basic principle of accounting is that if you explain the “accounting
treatment” to a man on the street, would you influence his investing decisions?
Would he sell or buy the stock based on a thorough understanding of the facts?
My concern is that the footnotes don’t adequately explain the transactions. If
adequately explained, the investor would know that the “Entities” described in our
related party footnote are thinly capitalized, the equity holders have no skin in the
game, and all the value in the entities comes from the underlying value of the
derivatives (unfortunately in this case, a big loss) AND Enron stock and N/P. . . .
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The related party footnote tries to explain these transactions. Don’t you think that
several interested companies, be they stock analysts, journalists, hedge fund
managers, etc., are busy trying to discover the reason Skilling left? Don’t you think
their smartest people are pouring [sic] over that footnote disclosure right now? I can
just hear the discussions—“It looks like they booked a $500 million gain from this
related party company and I think, from all the undecipherable ½ page on Enron’s
contingent contributions to this related party entity, I think the related party entity is
capitalized with Enron stock.”. . . . “No, no, no, you must have it all wrong, it can’t be
that, that’s just too bad, too fraudulent, surely AA & Co. wouldn’t let them get away
with that?”
Watkins was intimately familiar with aggressive accounting decisions made for a series of
large and complex transactions involving Enron and dozens of limited partnerships created
by the company. These partnerships were so-called SPEs or special purpose entities that
Enron executives had tagged with a variety of creative names, including Braveheart,
Rawhide, Raptor, Condor, and Talon. Andrew Fastow, Enron’s CFO who was involved in the
creation and operation of several of the SPEs, named a series of them after his three
children.
SPEs—sometimes referred to as SPVs (special purpose vehicles)—can take several legal
forms but are commonly organized as limited partnerships. During the 1990s, hundreds of
large corporations began establishing SPEs. In most cases, SPEs were used to finance the
acquisition of an asset or fund a construction project or related activity. Regardless, the
underlying motivation for creating an SPE was nearly always “debt avoidance.” That is,
SPEs provided large companies with a mechanism to raise needed financing for various
purposes without being required to report the debt in their balance sheets. Fortune
magazine charged that corporate CFOs were using SPEs as scalpels “to perform cosmetic
surgery on their balance sheets.”
During the early 1990s, the Securities and Exchange
Commission (SEC) and the FASB had wrestled with the contentious accounting and
financial reporting issues posed by SPEs. Despite intense debate and discussions, the SEC
and the FASB provided little in the way of formal guidance for companies to follow in
accounting and reporting for SPEs.
The most important guideline that the authoritative bodies implemented for SPEs, the socalled 3 percent rule, proved to be extremely controversial. This rule allowed a company to
omit an SPE’s assets and liabilities from its consolidated financial statements as long as
parties independent of the company provided a minimum of 3 percent of the SPE’s capital.
Almost immediately, the 3 percent threshold became both a technical minimum and a
practical maximum. That is, large companies using the SPE structure arranged for external
parties to provide exactly 3 percent of an SPE’s total capital. The remaining 97 percent of an
SPE’s capital was typically contributed by loans from external lenders, loans arranged and
generally collateralized by the company that created the SPE.
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Many critics charged that the 3 percent rule undercut the fundamental principle within the
accounting profession that consolidated financial statements should be prepared for entities
controlled by a common ownership group. “There is a presumption that consolidated
financial statements are more meaningful than separate statements and that they are
usually necessary for a fair presentation when one of the companies in the group directly or
indirectly has a controlling financial interest in the other companies.”
Business Week
chided the SEC and FASB for effectively endorsing the 3 percent rule.
Because of a gaping loophole in accounting practice, companies can create arcane
legal structures, often called special-purpose entities (SPEs). Then, the parent can
bankroll up to 97 percent of the initial investment in an SPE without having to
consolidate it. . . . The controversial exception that outsiders need invest only 3
percent of an SPE’s capital for it to be independent and off the balance sheet came
about through fumbles by the Securities and Exchange Commission and the
Financial Accounting Standards Board.
Throughout the 1990s, many companies took advantage of the minimal legal and
accounting guidelines for SPEs to divert huge amounts of their liabilities to off-balance sheet
entities. Among the most aggressive and innovative users of the SPE structure was Enron,
which created hundreds of SPEs. Unlike most companies, Enron did not limit its SPEs to
financing activities. In many cases, Enron used SPEs for the sole purpose of downloading
underperforming assets from its financial statements to the financial statements of related
but unconsolidated entities. For example, Enron would arrange for a third party to invest the
minimum 3 percent capital required in an SPE and then sell assets to that SPE. The SPE
would finance the purchase of those assets by loans collateralized by Enron common stock.
In some cases, undisclosed side agreements made by Enron with an SPE’s nominal owners
insulated those individuals from any losses on their investments and, in fact, guaranteed
them a windfall profit. Even more troubling, Enron often sold assets at grossly inflated prices
to their SPEs, allowing the company to manufacture large “paper” gains on those
transactions.
Enron made only nominal financial statement disclosures for its SPE transactions and those
disclosures were typically presented in confusing, if not cryptic, language. One accounting
professor observed that the inadequate disclosures that companies such as Enron provided
for their SPE transactions meant that, “the nonprofessional [investor] has no idea of the
extent of the [given firm’s] real liabilities.”
The Wall Street Journal added to that
sentiment when it suggested that Enron’s brief and obscure disclosures for its off-balance
sheet liabilities and related-party transactions “were so complicated as to be practically
indecipherable.”
Just as difficult to analyze for most investors was the integrity of the hefty profits reported
each successive period by Enron. As Sherron Watkins revealed in the letter she sent to
Kenneth Lay in August 2001, many of Enron’s SPE transactions resulted in the company’s
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profits being inflated by unrealized gains on increases in the market value of its own
common stock. In the fall of 2001, Enron’s board of directors appointed a Special
Investigative Committee chaired by William C. Powers, dean of the University of Texas Law
School, to study the company’s large SPE transactions. In February 2002, that committee
issued a lengthy report of its findings, a document commonly referred to as the Powers
Report by the press. This report discussed at length the “Byzantine” nature of Enron’s SPE
transactions and the enormous and improper gains those transactions produced for the
company.
Accounting principles generally forbid a company from recognizing an increase in
the value of its capital stock in its income statement. . . . The substance of the
Raptors [SPE transactions] effectively allowed Enron to report gains on its income
statement that were … [attributable to] Enron stock, and contracts to receive Enron
stock, held by the Raptors.
The primary motivation for Enron’s extensive use of SPEs and the related accounting
machinations was the company’s growing need for capital during the 1990s. As Kenneth
Lay and Jeffrey Skilling transformed Enron from a fairly standard natural gas supplier into a
New Economy intermediary for the energy industries, the company had a constant need for
additional capital to finance that transformation. Like most new business endeavors, Enron’s
Internet-based operations did not produce positive cash flows immediately. To convince
lenders to continue pumping cash into Enron, the company’s management team realized
that their firm would have to maintain a high credit rating, which, in turn, required the
company to release impressive financial statements each succeeding period.
A related factor that motivated Enron’s executives to window dress their company’s financial
statements was the need to sustain Enron’s stock price at a high level. Many of the SPE
loan agreements negotiated by Enron included so-called price “triggers.” If the market price
of Enron’s stock dropped below a designated level (trigger), Enron was required to provide
additional stock to collateralize the given loan, to make significant cash payments to the
SPE, or to restructure prior transactions with the SPE. In a worst-case scenario, Enron
might be forced to dissolve an SPE and merge its assets and liabilities into the company’s
consolidated financial statements.
What made Enron’s stock price so important was the fact that some of the
company’s most important deals with the partnerships [SPEs] run by Mr. Fastow—
deals that had allowed Enron to keep hundreds of millions of dollars of potential
losses off its books—were financed, in effect, with Enron stock. Those transactions
could fall apart if the stock price fell too far.
As Enron’s stock price drifted lower throughout 2001, the complex labyrinth of legal and
accounting gimmicks underlying the company’s finances became a shaky house of cards.
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Making matters worse were large losses suffered by many of Enron’s SPEs on the assets
they had purchased from Enron. Enron executives were forced to pour additional resources
into many of those SPEs to keep them solvent.
Contributing to the financial problems of Enron’s major SPEs was alleged selfdealing by
Enron officials involved in operating those SPEs. Andrew Fastow realized $30 million in
profits on his investments in Enron SPEs that he oversaw at the same time he was serving
as the company’s CFO. Several of his friends also reaped windfall profits on investments in
those same SPEs. Some of these individuals “earned” a profit of as much as $1 million on
an initial investment of $5,800. Even more startling was the fact that Fastow’s friends
realized these gains in as little as 60 days.
By October 2001, the falling price of Enron’s stock, the weight of the losses suffered by the
company’s large SPEs, and concerns being raised by Andersen auditors forced company
executives to act. Enron’s management assumed control and ownership of several of the
company’s troubled SPEs and incorporated their dismal financial statement data into
Enron’s consolidated financial statements. This decision led to the large loss reported by
Enron in the fall of 2001 and the related restatement of the company’s earnings for the
previous five years. On December 2, 2001, the transformed New Age company filed its
bankruptcy petition in New Age fashion—via the Internet. Only six months earlier, Jeffrey
Skilling had been buoyant when commenting on Enron’s first quarter results for 2001. “So in
conclusion, first-quarter results were great. We are very optimistic about our new
businesses and are confident that our record of growth is sustainable for many years to
come.”
As law enforcement authorities, Congressional investigative committees, and business
journalists rifled through the mass of Enron documents that became publicly available
during early 2002, the abusive accounting and financial reporting practices that had been
used by the company surfaced. Enron’s creative use of SPEs became the primary target of
critics; however, the company also made extensive use of other accounting gimmicks. For
example, Enron had abused the mark-to-market accounting method for its long-term
contracts involving various energy commodities, primarily natural gas and electricity. Given
the nature of their business, energy-trading firms regularly enter into long-term contracts to
deliver energy commodities. Some of Enron’s commodity contracts extended over periods
of more than 20 years and involved massive quantities of the given commodity. When Enron
finalized these deals, company officials often made tenuous assumptions that inflated the
profits booked on the contracts.
Energy traders must book all the projected profits from a supply contract in the
quarter in which the deal is made, even if the contract spans many years. That
means companies can inflate profits by using unrealistic price forecasts, as Enron
has been accused of doing. If a company contracted to buy natural gas through
2010 for $3 per thousand cubic feet, an energy-trading desk could aggressively
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assume it would be able to supply gas in each year at a cost of just $2, for a $1
profit margin.
The avalanche of startling revelations regarding Enron’s aggressive business, accounting,
and financial reporting decisions reported by the business press during the early weeks of
2002 created a firestorm of anger and criticism directed at Enron’s key executives,
principally Kenneth Lay, Jeffrey Skilling, and Andrew Fastow. A common theme of the
allegations leveled at the three executives was that they had created a corporate culture
that fostered, if not encouraged, “rule breaking.” Fortune magazine observed that, “If
nothing else, Lay allowed a culture of rule breaking to flourish,”
while Sherron Watkins
testified that Enron’s corporate culture was “arrogant” and “intimidating” and discouraged
employees from reporting and investigating ethical lapses and questionable business
dealings.
Finally, a top executive of Dynegy, a company that briefly considered merging
with Enron during late 2001, reported that “the lack of internal controls [within Enron] was
mind-boggling.”
Both Kenneth Lay and Andrew Fastow invoked their Fifth Amendment rights against selfincrimination when asked to testify before Congress in early 2002. Jeffrey Skilling did not.
While being peppered by Congressional investigators regarding Enron’s questionable
accounting and financial reporting decisions, Skilling replied calmly and repeatedly: “I am
not an accountant.”
A well-accepted premise in the financial reporting domain is that corporate executives and
their accountants are ultimately responsible for the integrity of their company’s financial
statements. Nevertheless, frustration stemming from the lack of answers provided by Enron
insiders to key accounting and financial reporting–related questions eventually caused
Congressional investigators, the business press, and the public to focus their attention, their
questions, and their scorn on Enron’s independent audit firm, Andersen. These parties
insisted that Andersen representatives explain why their audits of Enron had failed to result
in more transparent, if not reliable, financial statements for the company. More pointedly,
those critics demanded that Andersen explain how it was able to issue unqualified audit
opinions on Enron’s financial statements throughout its 15-year tenure as the company’s
independent audit firm.
Say It Ain’t So Joe
Joseph Berardino became Andersen’s chief executive shortly before the firm was swamped
by the storm of criticism surrounding the collapse of its second-largest client, Enron
Corporation. Berardino launched his business career with Andersen in 1972 immediately
after graduating from college and just a few months before Leonard Spacek ended his long
and illustrious career with the firm. Throughout its history, the Andersen firm had a policy of
speaking with one voice, the voice of its chief executive. So, the unpleasant task of
responding to the angry and often self-righteous accusations hurled at Andersen following
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Enron’s demise fell to Berardino, although he had not been a party to the key decisions
made during the Enron audits.
A common question directed at Berardino was whether his firm had been aware of the
allegations Sherron Watkins made during August 2001 and, if so, how had Andersen
responded to those allegations. Watkins testified before Congress that shortly after she
communicated her concerns regarding Enron’s questionable accounting and financial
reporting decisions to Kenneth Lay, she had met with a member of the Andersen firm with
whom she had worked several years earlier. In an internal Andersen memorandum, that
individual relayed Watkins’ concerns to several colleagues, including the Enron audit
engagement partner, David Duncan. At that point, Andersen officials in the firm’s Chicago
headquarters began systematically reviewing previous decisions made by the Enron audit
engagement team.
In fact, several months earlier, Andersen representatives had become aware of Enron’s
rapidly deteriorating financial condition and became deeply involved in helping the
company’s executives cope with that crisis. Andersen’s efforts included assisting Enron
officials in restructuring certain of the company’s SPEs so that they could continue to qualify
as unconsolidated entities. Subsequent press reports revealed that in February 2001,
frustration over the aggressive nature of Enron’s accounting and financial reporting
decisions caused some Andersen officials to suggest dropping the company as an audit
client.
On December 12, 2001, Joseph Berardino testified before the Committee on Financial
Services of the U.S. House of Representatives. Early in that testimony, Berardino freely
admitted that members of the Enron audit engagement team had made one major error
while analyzing a large SPE transaction that occurred in 1999. “We made a professional
judgment about the appropriate accounting treatment that turned out to be wrong.”
According to Berardino, when Andersen officials discovered this error in the fall of 2001,
they promptly notified Enron’s executives and told them to “correct it.” Approximately 20
percent of the $600 million restatement of prior earnings announced by Enron on November
8, 2001, was due to this item.
The remaining 80 percent of the earnings restatement involved another SPE that Enron
created in 1997. Unknown to Andersen auditors, one-half of that SPE’s minimum 3 percent
“external” equity had been effectively contributed by Enron. As a result, that entity did not
qualify for SPE treatment, meaning that its financial data should have been included in
Enron’s consolidated financial statements from its inception. When Andersen auditors
discovered this violation of the 3 percent rule in the fall of 2001, they immediately informed
Enron’s accounting staff. Andersen also informed the company’s audit committee that the
failure of Enron officials to reveal the source of the SPE’s initial funding could possibly be
construed as an illegal act under the Securities Exchange Act of 1934. Berardino implied
that the client’s lack of candor regarding this SPE exempted Andersen of responsibility for
the resulting accounting and financial reporting errors linked to that entity.
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Berardino also explained to Congress that Andersen auditors had been only minimally
involved in the transactions that eventually resulted in the $1.2 billion reduction of owners’
equity reported by Enron on October 16, 2001. The bulk of those transactions had occurred
in early 2001. Andersen had not audited the 2001 quarterly financial statements that had
been prepared following the initial recording of those transactions—public companies are
not required to have their quarterly financial statements audited.
Berardino’s testimony before Congress in December 2001 failed to appease Andersen’s
critics. Over the next several months, Berardino continually found himself defending
Andersen against a growing torrent of accusations. Most of these accusations centered on
three key issues. First, many critics raised the controversial and long-standing “scope of
services” issue when criticizing Andersen’s role in the Enron debacle. Over the final few
decades of the twentieth century, the major accounting firms had gradually extended the
product line of professional services they offered to their major audit clients. A research
study focusing on nearly 600 large companies that released financial statements in early
1999 revealed that for every $1 of audit fees those companies had paid their independent
auditors, they had paid those firms $2.69 for nonaudit consulting services.
These
services included a wide range of activities such as feasibility studies of various types,
internal auditing, design of accounting systems, development of e-commerce initiatives, and
a varied assortment of other information technology (IT) services.
In an interview with the New York Times in March 2002, Leonard Spacek’s daughter
revealed that her father had adamantly opposed accounting firms providing consulting
services to their audit clients. “I remember him ranting and raving, saying Andersen couldn’t
consult and audit the same firms because it was a conflict of interest. Well, now I’m sure
he’s twirling in his grave saying, ‘I told you so.’”
In the late 1990s, Arthur Levitt, the
chairman of the SEC, led a vigorous, one-man campaign to limit the scope of consulting
services that accounting firms could provide to their audit clients. In particular, Levitt wanted
to restrict the ability of accounting firms to provide IT and internal audit services to their audit
clients. An extensive and costly lobbying campaign that the Big Five firms carried out in the
press and among elected officials allowed those firms to defeat the bulk of Levitt’s
proposals.
Public reports that Andersen earned approximately $52 million in fees from Enron during
2000, only $25 million of which was directly linked to the 2000 audit, caused the scope of
services issue to resurface. Critics charged that the enormous consulting fees accounting
firms earned from their audit clients jeopardized those firms’ independence. “It’s obvious that
Andersen helped Enron cook the books. Andersen’s Houston office was pulling in $1 million
a week from Enron—their objectivity went out the window.”
These same critics reiterated
an allegation that had widely circulated a few years earlier, namely, that the large accounting
firms had resorted to using the independent audit function as “a loss leader, a way of getting
in the door at a company to sell more profitable consulting contracts.”
One former
partner of a Big Five accounting firm provided anecdotal evidence corroborating that
allegation. This individual revealed that he had been under constant pressure from his
former firm to market various professional services to his audit clients. So relentless were
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his efforts that at one point a frustrated client executive asked him, “Are you my auditor or a
salesperson?”
A second source of criticism directed at Andersen stemmed from the firm’s alleged central
role in Enron’s aggressive accounting and financial reporting treatments for its SPE-related
transactions. The Powers Report released to the public in February 2002 spawned much of
this criticism. That lengthy report examined in detail several of Enron’s largest and most
questionable SPE transactions. The Powers Report pointedly and repeatedly documented
that Andersen personnel had been deeply involved in those transactions. Exhibit 3 contains
a sample of selected excerpts from the Powers Report that refers to Andersen’s role in
“analyzing” and “reviewing” Enron’s SPE transactions.
Exhibit 3
Selected Excerpts from the Powers Report Regarding Andersen’s Involvement
in Key Accounting and Financial Reporting Decisions for Enron’s SPE
Transactions
Page 5: In virtually all of the [SPE] transactions, Enron’s accounting treatment was
determined with the extensive participation and structuring advice from Andersen,
which Management reported to the Board.
Page 17: Various disclosures [regarding Enron’s SPE transactions] were approved
by one or more of Enron’s outside [Andersen] auditors and its inside and outside
counsel. However, these disclosures were obtuse, did not communicate the
essence of the transactions completely or clearly, and failed to convey the
substance of what was going on between Enron and the partnerships.
Page 24: The evidence available to us suggests that Andersen did not fulfill its
professional responsibilities in connection with its audits of Enron’s financial
statements, or its obligation to bring to the attention of Enron’s Board (or the Audit
and Compliance Committee) concerns about Enron’s internal controls over the
related-party [SPE] transactions.
Page 24: Andersen participated in the structuring and accounting treatment of the
Raptor transactions, and charged over $1 million for its services, yet it apparently
failed to provide the objective accounting judgment that should have prevented
these transactions from going forward.
Page 25: According to recent public disclosures, Andersen also failed to bring to the
attention of Enron’s Audit and Compliance Committee serious reservations
Andersen partners voiced internally about the related-party transactions.
Page 25: The Board appears to have reasonably relied upon the professional
judgment of Andersen concerning Enron’s financial statements and the adequacy of
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controls for the related-party transactions. Our review indicates that Andersen failed
to meet its responsibilities in both respects.
Page 100: Accountants from Andersen were closely involved in structuring the
Raptors [SPE transactions]. . . . Enron’s records show that Andersen billed Enron
approximately $335,000 in connection with its work on the creation of the Raptors in
the first several months of 2000.
Page 107: Causey [Enron’s chief accounting officer] informed the Finance
Committee that Andersen “had spent considerable time analyzing the Talon
structure and the governance structure of LJM2 and was comfortable with the
proposed [SPE] transaction.”
Page 126: At the time [September 2001], Enron accounting personnel and Andersen
concluded (using qualitative analysis) that the error [in a prior SPE transaction] was
not material and a restatement was not necessary.
Page 129: Proper financial accounting does not permit this result [questionable
accounting treatment for certain of Enron’s SPE transactions]. To reach it, the
accountants at Enron and Andersen—including the local engagement team and,
apparently, Andersen’s national office experts in Chicago—had to surmount
numerous obstacles presented by pertinent accounting rules.
Page 132: It is particularly surprising that the accountants at Andersen, who should
have brought a measure of objectivity and perspective to these transactions, did not
do so. Based on the recollections of those involved in the transactions and a large
collection of documentary evidence, there is no question that Andersen accountants
were in a position to understand all the critical features of the Raptors and offer
advice on the appropriate accounting treatment. Andersen’s total bill for Raptorrelated work came to approximately $1.3 million. Indeed, there is abundant evidence
that Andersen in fact offered Enron advice at every step, from inception through
restructuring and ultimately to terminating the Raptors. Enron followed that advice.
Page 202: While we have not had the benefit of Andersen’s position on a number of
these issues, the evidence we have seen suggests Andersen accountants did not
function as an effective check on the disclosure approach taken by the company.
Andersen was copied on drafts of the financial statement footnotes and the proxy
statements, and we were told that it routinely provided comments on the relatedparty transaction disclosures in response. We also understand that the Andersen
auditors closest to Enron Global Finance were involved in drafting of at least some
of the disclosures. An internal Andersen e-mail from February 2001 released in
connection with recent Congressional hearings suggests that Andersen may have
had concerns about the disclosures of the related-party transactions in the financial
statement footnotes. Andersen did not express such concerns to the Board. On the
contrary, Andersen’s engagement partner told the Audit and Compliance Committee
just a week after the internal e-mail that, with respect to related-party transactions,
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“‘[r]equired disclosure [had been] reviewed for adequacy,’ and that Andersen would
issue an unqualified audit opinion on the financial statements.”
Source: W. C. Powers, R. S. Troubh, and H. S. Winokur, “Report of Investigation by the Special
Investigative Committee of the Board of Directors of Enron Corporation,” February 1, 2002.
Among the parties most critical of Andersen’s extensive involvement in Enron’s accounting
and financial reporting decisions for SPE transactions was former SEC Chief Accountant
Lynn Turner. During his tenure with the SEC in the 1990s, Turner had participated in the
federal agency’s investigation of Andersen’s audits of Waste Management, Inc. That
investigation culminated in sanctions against several Andersen auditors and in a $1.4 billion
restatement of Waste Management’s financial statements, the largest accounting
restatement in U.S. history at that time. Andersen eventually paid a reported $75 million in
settlements to resolve various civil lawsuits linked to those audits and a $7 million fine to
settle charges filed against the firm by the SEC.
In an interview with the New York Times, Turner suggested that the charges of shoddy audit
work that plagued Andersen in connection with its audits of Waste Management, Sunbeam,
Enron, and other high-profile public clients was well-deserved. Turner compared Andersen’s
problems with those experienced several years earlier by Coopers & Lybrand, a firm for
which he had been an audit partner. According to Turner, a series of “blown audits” was the
source of Coopers’ problems. “We got bludgeoned to death in the press. People did not
even want to see us at their doorsteps. It was brutal, but we deserved it. We had gotten into
this mentality in the firm of making business judgment calls.”
Clearly, the role of
independent auditors does not include “making business judgments” for their clients.
Instead, auditors have a responsibility to provide an objective point of view regarding the
proper accounting and financial reporting decisions for those judgments.
Easily the source of the most embarrassment for Berardino and his Andersen colleagues
was the widely publicized effort of the firm’s Houston office to shred a large quantity of
documents pertaining to various Enron audits. In early January 2002, Andersen officials
informed federal investigators that personnel in the Houston office had “destroyed a
significant but undetermined number of documents relating to the company [Enron] and its
finances.”
That large-scale effort began in September 2001 and apparently continued
into November after the SEC revealed it was conducting a formal investigation of Enron’s
financial affairs. The report of the shredding effort immediately caused many critics to
suggest that Andersen’s Houston office was attempting to prevent law enforcement
authorities from obtaining potentially incriminating evidence regarding Andersen’s role in
Enron’s demise. Senator Joseph Lieberman, chairman of the U.S. Senate Governmental
Affairs Committee that would be investigating the Enron debacle, warned that the effort to
dispose of the Enron-related documents might be particularly problematic for Andersen.
It [the document-shredding] came at a time when people inside, including the
executives of Arthur Andersen and Enron, knew that Enron was in real trouble and
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that the roof was about to collapse on them, and there was about to be a corporate
scandal. . . . [This] raises very serious questions about whether obstruction of
justice occurred here. The folks at Arthur Andersen could be on the other end of an
indictment before this is over. This Enron episode may end this company’s history.
The barrage of criticism directed at Andersen continued unabated during the early months
of 2002. Ironically, some of that criticism was directed at Andersen by Enron’s top
management. On January 17, 2002, Kenneth Lay issued a press release reporting that his
company had decided to discharge Andersen as its independent audit firm.
In the press
release, Lay justified that decision by referring to the “reported destruction” of audit
documents by the Enron audit team and to the fact that several Andersen partners in the
firm’s Houston office had faced “disciplinary actions” as a result of their conduct on Enron
audits.
Throughout the public relations nightmare that besieged Andersen following Enron’s
bankruptcy filing, a primary tactic employed by Joseph Berardino was to insist repeatedly
that poor business decisions, not errors on the part of Andersen, were responsible for
Enron’s downfall and the massive losses that ensued for investors, creditors, and other
parties. “At the end of the day, we do not cause companies to fail.”
Such statements
failed to generate sympathy for Andersen. Even the editor in chief of Accounting Today, one
of the accounting profession’s leading publications, was unmoved by Berardino’s continual
assertions that his firm was not responsible for the Enron fiasco. “If you accept the audit and
collect the fee, then be prepared to accept the blame. Otherwise you’re not part of the
solution but rather, part of the problem.”
Ridicule and Retrospection
As 2001 came to a close, the New York Times reported that the year had easily been the
worst ever for Andersen, “the accounting firm that once deserved the title of the conscience
of the industry.”
The following year would prove to be an even darker time for the firm.
During the early months of 2002, Andersen faced scathing criticism from Congressional
investigators, enormous class-action lawsuits filed by angry Enron stockholders and
creditors, and a federal criminal indictment stemming from the shredding of Enron-related
documents.
In late March 2002, Joseph Berardino unexpectedly resigned as Andersen’s CEO after
failing to negotiate a merger of Andersen with one of the other Big Five firms. During the
following few weeks, dozens of Andersen clients dropped the firm as their independent
auditor out of concern that the firm might not survive if it was found guilty of the pending
criminal indictment. The staggering loss of clients forced Andersen to lay off more than 25
percent of its workforce in mid-April. Shortly after that layoff was announced, U.S. Justice
Department officials revealed that David Duncan, the former Enron audit engagement
partner, had pleaded guilty to obstruction of justice and agreed to testify against his former
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firm. Duncan’s plea proved to be the death knell for Andersen. In June 2002, a federal jury
found the firm guilty of obstruction of justice. That conviction forced the firm to terminate its
relationship with its remaining public clients, effectively ending Andersen’s long and proud
history within the U.S. accounting profession.
Three years later, the U.S. Supreme Court unanimously overturned the felony conviction
handed down against Andersen. In an opinion written by Chief Justice William Rehnquist,
the high court ruled that federal prosecutors did not prove that Andersen had intended to
interfere with a federal investigation when the firm shredded the Enron audit workpapers.
The Supreme Court’s decision was little consolation to the more than 20,000 Andersen
partners and employees who had lost their jobs when the accounting firm was forced out of
business by the felony conviction.
Numerous Enron officials faced criminal indictments for their roles in the Enron fraud,
among them Andrew Fastow, Jeffrey Skilling, and Kenneth Lay. Fastow pleaded guilty to
conspiracy to commit securities fraud as well as to other charges. The former CFO received
a 10-year prison term, which was reduced to 6 years after he testified against Skilling and
Lay. Fastow was also required to forfeit nearly $25 million of personal assets that he had
accumulated during his tenure at Enron. Largely as a result of Fastow’s testimony against
them, Skilling and Lay were convicted on multiple counts of fraud and conspiracy in May
2006. Four months later, Skilling was sentenced to 24 years in prison but that sentence was
shortened to 14 years in 2013. Kenneth Lay died of a massive heart attack in July 2006.
Three months later, a federal judge overturned Lay’s conviction since Lay was no longer
able to pursue his appeal of that conviction.
The toll taken on the public accounting profession by the Enron debacle was not limited to
Andersen, its partners, or its employees. An unending flood of jokes and ridicule directed at
Andersen tainted and embarrassed practically every accountant in the nation, including both
accountants in public practice and those working in the private sector. The Enron nightmare
also prompted widespread soul-searching within the profession and a public outcry to
strengthen the independent audit function and improve accounting and financial reporting
practices. Legislative and regulatory authorities quickly responded to the public’s demand
for reforms.
The FASB imposed stricter accounting and financial reporting guidelines on SPEs as a
direct result of the Enron case. Those new rules require most companies to include the
financial data for those types of entities in their consolidated financial statements. In 2002,
Congress passed the Sarbanes–Oxley Act to strengthen financial reporting for public
companies, principally by improving the rigor and quality of independent audits. Among
other requirements, the Sarbanes–Oxley Act limits the types of consulting services that
independent auditors can provide to their clients and requires public companies to prepare
annual reports on the quality of their internal controls. The most sweeping change in the
profession resulting from the Enron fiasco was the creation of a new federal agency, the
Public Company Accounting Oversight Board, to oversee the independent audit function for
SEC registrants.
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Among the prominent individuals who commented on the challenges and problems facing
the accounting profession was former SEC Chairman Richard Breeden when he testified
before Congress in early 2002. Chairman Breeden observed that there was a simple
solution to the quagmire facing the profession. He called on accountants and auditors to
adopt a simple rule of thumb when analyzing, recording, and reporting on business
transactions, regardless of whether those transactions involved “New Economy” or “Old
Economy” business ventures. “When you’re all done, the result had better fairly reflect what
you see in reality.”
In retrospect, Commissioner Breeden’s recommendation seems to be a restatement of the
“Think straight, talk straight” motto of Arthur E. Andersen. Andersen and his colleagues
insisted that their audit clients adhere to a high standard of integrity when preparing their
financial statements. An interview with Joseph Berardino by the New York Times in
December 2001 suggests that Mr. Berardino and his contemporaries may have had a
different attitude when it came to dealing with cantankerous clients such as Enron: “In an
interview yesterday, Mr. Berardino said Andersen had no power to force a company to
disclose that it had hidden risks and losses in special-purpose entities. ‘A client says: “There
is no requirement to disclose this. You can’t hold me to a higher standard.”’”
Berardino is certainly correct in his assertion. An audit firm cannot force a client to adhere to
a higher standard. In fact, even Arthur Edward Andersen did not have that power. But Mr.
Andersen did have the resolve to tell such clients to immediately begin searching for
another audit firm.
Chapter : Knapp Cases Enron Corporation
Book Title: Auditing: A Risk-Based Approach
Printed By: Angel Oliva (Angel.Oliva004@mymdc.net)
© 2019 Cengage Learning, Cengage Learning
© 2023 Cengage Learning Inc. All rights reserved. No part of this work may by reproduced or used in any form or by any means graphic, electronic, or mechanical, or in any other manner – without the written permission of the copyright holder.
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