Auditing Failures at Enron Case Study Questions

Read the case and answer the question 3 and 6, please following the following 4 section to answer the questions.

Section 1: brief summary of the key facts of the case – this should be no longer than a paragraph (or one slide forpresenting groups).• Section 2: A list of the professional standards applicable to the case. Each of your listings should include the codificationnumber and title of the standard as well as a reference to the pertinent paragraph(s) within the standard if appropriate.E.g. PCAOB AS 2401: Consideration of Fraud in a Financial Statement Audit paragraphs .13-.52• Section 3: Responses to all the questions required for the case study. Be sure to support your response with cites ofapplicable standards (which you would have listed above) as appropriate. Organize your responses in the same order thequestions are asked in the case study. Start each response by first restating the question.• Section 4: Reflect on all of the questions/responses in section three. Given your critical analysis of the case materials,think about any other relevant questions about the case you would like to have answers to that weren’t asked as part ofthe required case study questions. List 1-3 questions you would like to pose to the group leading the case studypresentation in class. CASE 1.5
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 Chicagobased 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 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
55
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56
SECTION ONE
COMPREHENSIVE CASES
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, fourword 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.”1
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 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
1. R. Frammolino and J. Leeds, “Andersen’s Reputation in Shreds,” Los Angeles Times (online),
30 January 2002.
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CASE 1.5
ENRON CORPORATION
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.”2 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).
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 coldstricken and shallow-pocketed consumers to become Northern customers.
2. Ibid.
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58
SECTION ONE
COMPREHENSIVE CASES
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 growththrough-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 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 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. 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.
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CASE 1.5
ENRON CORPORATION
59
2000
1999
1998
1997
1996
$100,789
$40,112
$31,260
$20,273
$13,289
1,266
957
698
515
493
(287)
979
(64)
893
5
703
(410)
105
91
584
1.47
1.18
1.00
.87
.91
(.35)
1.12
(.08)
1.10
.01
1.01
(.71)
.16
.17
1.08
.50
.50
.48
.46
.43
Total Assets:
65,503
33,381
29,350
22,552
16,137
Cash from Operating
Activities:
3,010
2,228
1,873
276
742
Capital Expenditures and
Equity Investments:
3,314
3,085
3,564
2,092
1,483
NYSE Price Range:
High
Low
Close, December 31
90.56
41.38
83.12
44.88
28.75
44.38
29.38
19.06
28.53
22.56
17.50
20.78
23.75
17.31
21.56
Revenues
Net Income:
Operating Results
Items Impacting
Comparability
Total
Earnings Per Share:
Operating Results
Items Impacting
Comparability
Total
Dividends Per Share:
EXHIBIT 1
ENRON
CORPORATION
2000 A NNUAL
R EPORT FINANCIAL
HIGHLIGHTS TABLE
(IN MILLIONS EXCEPT
FOR PER SHARE
AMOUNTS)
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 Presidentelect George W. Bush. 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.”3
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.”4
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.”5
3. K. Eichenwald and D. B. Henriques, “Web of Details Did Enron In as Warnings Went Unheeded,” New
York Times (online), 10 February 2002.
4. E. Thomas, “Every Man for Himself,” Newsweek, 18 February 2002, 25.
5. Eichenwald and Henriques, “Web of Details.”
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60
SECTION ONE
COMPREHENSIVE CASES
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.”6
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.”7 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 long-range 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 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
6. Ibid.
7. N. Byrnes, “Paying for the Sins of Enron,” Newsweek, 11 February 2002, 35.
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CASE 1.5
ENRON CORPORATION
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.”8
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.”9 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 so-called 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
8. T. Hamburger, “Watkins Tells of ‘Arrogant’ Culture; Enron Stifled Staff Whistle-Blowing,” Wall Street
Journal (online), 14 February 2002.
9. J. Kahn, “Off Balance Sheet—and Out of Control,” Fortune, 18 February 2002, 84.
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62
SECTION ONE
COMPREHENSIVE CASES
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.
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
EXHIBIT 2
SELECTED E XCERPTS
FROM SHERRON
WATKINS’ AUGUST
2001 LETTER TO
K ENNETH L AY
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. . . .
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?”
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CASE 1.5
ENRON CORPORATION
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.”10
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.11
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.”12 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.”13
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 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.
10. Accounting Research Bulletin No. 51, “Consolidated Financial Statements” (New York: AICPA, 1959).
11. D. Henry, H. Timmons, S. Rosenbush, and M. Arndt, “Who Else Is Hiding Debt?” Business Week,
28 January 2002, 36–37.
12. Ibid.
13. J. Emshwiller and R. Smith, “Murky Waters: A Primer on the Enron Partnerships,” Wall Street Journal
(online), 21 January 2002.
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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 Raptors14
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 far15
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. 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 self-dealing
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 wind-fall 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
14. 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,” 1 February 2002, 129–130.
15. Eichenwald and Henriques, “Web of Details.”
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CASE 1.5
ENRON CORPORATION
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.”16
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 assume it would be able to supply gas in each year at a cost of just $2, for a $1 profit margin.17
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,”18 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.19 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.”20
Both Kenneth Lay and Andrew Fastow invoked their Fifth Amendment rights
against self-incrimination 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
16. Ibid.
17. P. Coy, S. A. Forest, and D. Foust, “Enron: How Good an Energy Trader?” Business Week, 11 February
2002, 42–43.
18. B. McLean, “Monster Mess,” Fortune, 4 February 2002, 94.
19. Hamburger, “Watkins Tells of ‘Arrogant’ Culture.”
20. N. Banjeree, D. Barboza, and A. Warren, “At Enron, Lavish Excess Often Came before Success,” New
York Times (online), 26 February 2002.
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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 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.21
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.”22 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.
21. S. Labaton, “S.E.C. Leader Sees Outside Monitors for Auditing Firms,” New York Times (online),
18 January 2002.
22. J. Kahn and J. D. Glater, “Enron Auditor Raises Specter of Crime,” New York Times (online),
13 December 2001.
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CASE 1.5
ENRON CORPORATION
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.
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.23 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.’”24 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
23. N. Byrnes, “Accounting in Crisis,” Business Week, 28 January 2002, 46.
24. D. Barboza, “Where Pain of Arthur Andersen Is Personal,” New York Times (online), 13 March 2002.
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window.”25 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.”26 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 his efforts that at one
point a frustrated client executive asked him, “Are you my auditor or a salesperson?”27
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.
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.”28
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.”29 That large-scale effort began in
September 2001 and apparently continued into November after the SEC revealed it
25. SmartPros.com, “Lawsuit Seeks to Hold Andersen Accountable for Defrauding Enron Investors,
Employees,” 4 December 2001.
26. J. Kahn, “One Plus One Makes What?” Fortune, 7 January 2002, 89.
27. I. J. Dugan, “Before Enron, Greed Helped Sink the Respectability of Accounting,” Wall Street Journal
(online), 14 March 2002.
28. F. Norris, “From Sunbeam to Enron, Andersen’s Reputation Suffers,” New York Times (online),
23 November 2001.
29. K. Eichenwald and F. Norris, “Enron Auditor Admits It Destroyed Documents,” New York Times
(online), 11 January 2002.
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CASE 1.5
ENRON CORPORATION
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 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 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.
69
EXHIBIT 3
SELECTED E XCERPTS
FROM THE POWERS
R EPORT R EGARDING
A NDERSEN’S
INVOLVEMENT IN
K EY ACCOUNTING
AND F INANCIAL
R EPORTING
DECISIONS FOR
ENRON’S SPE
TRANSACTIONS
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 related-party 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, “‘[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.
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 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.30
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.31 In the press release, Lay justified that decision by referring to the “reported
30. R. A. Oppel, “Andersen Says Lawyer Let Its Staff Destroy Files,” New York Times (online), 14 January 2002.
31. Kenneth Lay resigned as Enron’s chairman of the board and CEO on January 23, 2002, one day after
a court-appointed “creditors committee” had requested him to step down.
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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.32
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.”33 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.”34
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.”35 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 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
32. M. Palmer, “Enron Board Discharges Arthur Andersen in All Capacities,” Enron.com, 17 January
2002.
33. M. Gordon, “Labor Secretary to Address Enron Hearings,” Associated Press (online), 6 February 2002.
34. B. Carlino, “Enron Simply Newest Player in National Auditing Crisis,” The Electronic Accountant
(online), 17 December 2001.
35. Norris, “From Sunbeam to Enron.”
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CASE 1.5
ENRON CORPORATION
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.
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.”36
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.”’”37
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
36. R. Schlank, “Former SEC Chairmen Urge Congress to Free FASB,” AccountingWeb (online), 15
February 2002.
37. F. Norris, “The Distorted Numbers at Enron,” New York Times (online), 14 December 2001.
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
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71
72
SECTION ONE
COMPREHENSIVE CASES
that power. But Mr. Andersen did have the resolve to tell such clients to immediately
begin searching for another audit firm.38
Questions
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 were most responsible for that crisis. Briefly justify each
of your choices.
2. List three types of consulting services that audit firms are now prohibited from
providing to clients that are public companies. For each item, indicate the
specific threats, if any, that the provision of the given service could pose for an
audit firm’s independence.
3. For purposes of this question, assume that the excerpts from the Powers Report
shown in Exhibit 3 provide accurate descriptions of Andersen’s involvement in
Enron’s accounting and 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.
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?
5. Identify five recommendations made to strengthen the independent audit
function following the Enron scandal. For each of these recommendations,
indicate why you support or do not support the given measure. Also indicate
which of these recommendations were eventually implemented.
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.
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.
38. In August 2015, the SEC reported that it was closing the Enron Victim Trust. That trust had been
established by the federal agency to disburse financial settlements collected from defendants in Enronrelated legal actions filed by the SEC and the U.S. Department of Justice. In total, more than $500 million
was paid from the Enron Victim Trust to the company’s former stockholders. Published reports indicate
that more than $20 billion has been distributed to Enron’s former creditors and stockholders as a result
of successful civil lawsuits filed against a wide range of parties, including several of the company’s former banks. Those recoveries represent a fraction of the almost $100 billion in losses suffered by Enron’s
former creditors and stockholders.
Copyright 2022 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
Copyright 2022 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

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