GROUP ASSIGNMENT:

Audit Case of
Enron Corporation and Andersen, LLP (Case 4.1)

By Group Accounting Class - Auditing:

Amellia Samantha / 008201500036
Jersey Purba / 008201500057
Samuel Alexander / 008201500028
Stephanie Angelica / 008201500095
Batch 2015
Auditing Seminar Subject
Lecturer: Gatot Imam Nugroho

President University
Jalan Ki Hajar Dewantara, Cikarang,
West Java - Indonesia
(021) 89109762

May 2017
 Case 4.1 ENRON CORPORATION AND ANDERSEN, LLP
Analyzing the Fall of Two Giants

Summary
Enron's origins date back to 1985 when it began life as an interstate pipeline company
through the merger of Houston Natural Gas and Omaha-based Inter North. Kenneth Lay, the
former chief executive officer of Houston Natural Gas, became CEO, and the next year won the
post of chairman. From the pipeline sector, Enron began moving into new fields. In 1999, the
company launched its broadband services unit and Enron Online, the company's website for
trading commodities, which soon became the largest business site in the world. About 90 per cent
of its income eventually came from trades over Enron Online.
Growth for Enron was rapid. In 2000, the company's annual revenue reached$100 billion
US. It ranked as the seventh-largest company on the Fortune 500 and the sixth-largest energy
company in the world. The company's stock price peaked at $90 US. However, cracks began to
appear in 2001. In August of that year, Jeffrey Skilling, a driving force in Enron's revamp and the
company's CEO of six months, announced his departure, and Lay resumed the post of CEO. In
October 2001, Enron reported a loss of $618 million— its first quarterly loss in four years. Chief
financial officer Andrew Fastow was replaced, and the U.S. Securities and Exchange commission
launched an investigation into investment partnerships led by Fastow. That investigation would
later show that a complex web of partnerships was designed to hide Enron's debt.
Enron reported annual revenues of about $101 billion between 1985 and 2000. On
December 18, 2000, Enron's stock sold for $84.87 per share. Stock prices fell throughout 2001,
and on October 16, 2001, the company reported losses of $638 million in the third quarter alone.
During the next six weeks, company stock continued to fall, and by December 2, 2001, Enron
stock dropped to below $1 per share after the largest single day trading volume for any stock
listed on either the New York Stock Exchange or the NASDAQ. On Dec. 2, 2001, Enron filed
for bankruptcy protection in the biggest case of bankruptcy in the United States up to that point.
5,600 Enron employees subsequently lost their jobs. The next month, the U.S. Justice
Department opened its investigation of the company's dealings, and Ken Lay quit as chairman
and CEO.
The controversy extended to Arthur Andersen, which was accused of overlooking
significant sums of money that had not been represented on Enron's books. Arthur Andersen was
later found guilty on federal charges that it obstructed justice by destroying thousands of
documents related to Enron. Initial allegations focused on the role of Arthur Andersen. The
company was one of the "Big Five" accounting firms in the United States, and it had served as
Enron's auditor for 16 years. According to court documents, Enron and Arthur Andersen had
improperly categorized hundreds of millions of dollars as increases in shareholder equity,
thereby misrepresenting the true value of the corporation. Arthur Andersen also did not follow
generally accepted accounting principles (GAAP) when it considered Enron's dealings with
related partnerships. These dealings helped Enron to conceal some of its losses.
Arthur Andersen was also accused of destroying thousands of Enron documents that
included not only physical documents but also computer files and E-Mail files. After
investigation by the US Justice Department, the firm was indicted on obstruction of justice
charges in March 2002. After a six-week trial, Arthur Andersen was found guilty on June 16,
2002. The company was placed on probation for five years and was required to pay a $500,000
fine.
Learning Objectives
1. Understand the events leading to Enron’s bankruptcy and Andersen’s downfall
Factors that Contributed to Enron’s bankruptcy:
 Corporate culture and reward system.
 Quality of oversight provided by board of directors.
 Remuneration provided to board of directors.
 Market ideology of top management.
 Nature of contract with auditors, Arthur Andersen.
 Approach taken by corporate lawyers.
 Lobbying of regulators.
 Relationship with elected officials.
 Ethics of top corporate officials.
 Managing the stock price, to the exclusion of all else.
 Lying to shareholders and the investment community.
 Manipulating revenue by mark to market accounting.
 Mandating that pensions be held in Enron stock.

Factors that Contributed to Andersen’s downfall:

 The failure to acknowledge the conflict of interest in providing consulting services to
the same companies, they were auditing. The auditors saw the conflict and knew it
was wrong. Unfortunately, the profits outweighed the ethical standards of the
company.
 A second concern of unethical practices was brought to the attention of the leadership
team regarding conflict of interest, which was brought up by an auditor. Rather than
rectifying the situation, they avoided it. The team disregarded the notion of conflict of
interest and removed the auditor as well as any hard copies suggesting that there was
a conflict of interest. Furthermore, their actions subjected them into illegal behaviour
due to the destruction of the files.
 Manipulating the financials of firms they were auditing. Consulting was a more
viable option for Anderson, which resulted, in them letting the auditing side of their
business suffer, because consulting proved to be more profitable.
 Conflict of interest with associates acting as consultants, as well, as auditors for the
same company. As a result, consultants do not necessarily act in the best interest of
the client, rather for themselves as they make more money.
2. Appreciate the importance of understanding an audit client’s core business strategies
As stated in ISA 310, auditors are required to obtain a reasonable understanding
of the clien’s business and industry. The nature of the client’s business and industry
affects client business risk and the risk of material misstatement in the financial
statements. Auditors use the knowledge of these risks to determine the appropriate
amount of audit evidence to gather. Auditors have been exposed to problems resulting
from the auditor’s failure to understand comprehensively the nature of transactions in
client’s industry.

3. Recognize potential conflicts arising from auditor relationships with their clients
Accountants in public practice should be independent in fact and appearance
when providing auditing and other attestation services. If auditor provide attestation or
assurance services to clients, a conflict of interest will prevent auditor from also
providing investment advisory services.

Specifically, conflict of interest situations include:

 General requirements, including the provision of certain non-audit services, and
 Specific relationships of the auditor and/or audit team members with the audited
entity,

Furthermore, AICPA rules state that an accountant’s independence will be

impaired if the accountant:
 Makes investment decisions on behalf of audit clients or otherwise has
discretionary authority over an audit client’s investments.
 Executes a transaction to buy or sell an audit client’s investment.
 Has custody of assets of the audit client, such as taking temporary possession of
securities purchased by the audit client.

4. Understand how accounting standards may have contributed to the Enron debacle and
describe how the accounting profession is seeking to change the fundamental nature of
those standards
Prior to the fall of Enron and their accountants, Arthur Andersen, there were many
different types of safety measures in place to help protect the investors and the public as a
whole. These safety measures included Generally Accepted Accounting Principles
(GAAP), Generally Accepted Auditing Standards (GAAS), Statements on Auditing
Standards (SAS), and all professional ethics. The use of GAAP by accountants is
standard protocol. An accountant follows these principles as a matter of daily routine.
According to Several accounting texts, GAAP is identified as a “dynamic set of both
broad and specific guidelines that companies should follow when measuring and
reporting the information in their financial statements.”
 During yearly audits performed by external, independent auditors, checks are
performed to make sure that a business is following GAAP consistently. If they are not,
then the business must show why they are not, and present rationale to demonstrate that
what they are doing is both ethical and appropriate in their specific situation. This leaves
the field open to interpretations of what is appropriate for different situations. Since
interpretations are quite subjective, the American Institute of Certified Public
Accountants (AICPA), added the stipulation that the treatment must also be applied
consistently over time. These rules are in place to make financial statements as accurate
and reliable as possible. Enron took these rules and circumvented them to allow certain
individuals within the company to make money from the increased investments from
stockholders. They did this by bolstering their balance sheet with inflated asset values,
and dispersing their liabilities to subsidiaries that they just didn’t consolidate. Meaning
that Enron didn’t include these companies in their financial statement accounts at the end
of their fiscal years, causing massive misstatements. Since these partnerships were, in
most cases, wholly owned subsidiaries or partnerships, they should have been shown on
the consolidated financial statements with Enron.

Since these events have taken place, many changes have come about within the
accounting industry. Some of these changes originated with the AICPA and other
accounting groups. Still other changes have come from the government and government
agencies or have just naturally evolved with time.

The AICPA made several new Statements on Auditing Standards in response to

the Enron events. The three that appear to be most closely linked to the Enron and
Andersen debacle are SAS 96, SAS 98, and SAS 99. SAS 96 became effective January
of 2002 and dealt with the record retention policies of accounting firms. In SAS 96 the
requirements of SAS 41, which was the first SAS to address record retention, were
reaffirmed. Also several new regulations were added. SAS 96 contains a list of factors
that auditors should consider when attempting to determine the nature and extent of
documentation for a particular audit area and procedure. It also requires auditors to
document all decisions or judgments that are of a significant degree (SAS 96). For
example, a decision of a significant degree would be an auditor approving a client not
using GAAP for a portion of their financial statements. These changes appear to be a
direct result of the paper shredding that went on at Arthur Andersen immediately after the
Enron bankruptcy. SAS 98 makes a lot of revisions and amendments to previous
statements. These changes include changes to GAAS, changes to the relationship
between GAAS and quality control standards, and audit risk and materiality concepts in
audits (SAS 98). All of these changes would appear to be related to problems that were
discovered in the Andersen audit of Enron. SAS 99 outlines what fraud is, reaffirms the
auditor’s responsibility to look for fraud, and reaffirms the necessity to gather all
information for an audit (SAS 99). These changes appear to be in connection to the fact
that Anderson did not find any fraud in Enron’s books, where fraud existed. These
changes all came from within the AICPA.
 All in all, executives at Arthur Andersen and Enron did not set out to have a
positive impact on the accounting industry or any industry. They set out to make as much
money for themselves as quickly as possible. They were willing to do whatever it took to
make that money. These thoughtless acts and greed led both companies to an eventual
downfall in bankruptcy. However, the accounting industry reacted by introducing
changes that would, in the long run, improve itself and the economy in which it exists.
The changes that are a response to the Andersen/Enron debacle may be coming to an end.
We are probably seeing the last laws, pronouncements, and statements that are a direct
result of these actions. Still, the changes that have occurred leave the accounting industry
and the economy stronger.

5. Consider challenges facing the accounting profession and evaluate alternative courses of
action for overcoming these obstacles
An accountant working in the public or private sector must remain impartial and
loyal to ethical guidelines when reviewing a company or individual's financial records for
reporting purposes. An accountant frequently encounters ethical issues regardless of the
industry and must remain continually vigilant to reduce the chances of outside forces
manipulating financial records, which could lead to both ethical and criminal violations.

Some of these ethical issues include:

 Pressure From Management
The burden for public companies to succeed at high levels may place undue stress
and pressure on accountants creating balance sheets and financial statements. The
ethical issue for these accountants becomes maintaining true reporting of
company assets, liabilities and profits without giving in to the pressure placed on
them by management or corporate officers.
 Accountant as Whistle-blower
An accountant may face the ethical dilemma of reporting discovered accounting
violations to the Financial Accounting Standards Board. While it is an ethical
accountant's duty to report such violations, the dilemma arises in the ramifications
of the reporting.
 The Effects of Greed
Greed in the business and finance world leads to shaving ethical boundaries and
stepping around safeguards in the name of making more money. An accountant
can never let the desire to earn a better living and acquire more possessions get in
the way of ensuring that she follows ethical guidelines for financial reporting
 Omission of Financial Records
A corporate officer or other executive may ask an accountant to omit or leave out
certain financial figures from a balance sheet that may paint the business in a bad
light to the public and investors. Omission may not seem like a significant breach
of accounting ethics to an accountant because it does not involve direct
manipulation of numbers or records.
 All in all, all of these are precisely why an accountant must remain ethically
vigilant to avoid falling into such ethical dilemma and always be competent, independent,
and professional.
Required

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

The business risks that Enron faced included foreign currency risks and price
instability, which is common for the energy industry. In addition, Enron faced pressure to
perform well so that the stock price would rise.

These risks increased the likelihood of material misstatements in the financial

statements for several reasons. Since Enron operated in other countries, there would be a
foreign currency risks and those could lead to gains/losses not being properly calculated
or accrued on hedging activities. By operating in foreign countries, there are political
risks such as policy changes, lack of understanding of culture and business practices. The
biggest risk is having the pressure to report good financial results. The deals with the
special purpose entities (“SPE’s”) depended on a high stock price. The company used its
stock as collateral if the stock price fell below a certain price. At that point, Enron would
have to use the stock to pay out the investors. The company also had pressure from its
business partners to perform well and meet its future obligations. If the company
performed poorly, the investors may hesitate to do business with Enron.

2. What are the responsibilities of a company’s board of directors? Could the board of
directors at Enron—especially the audit committee—have prevented the fall of Enron?
Should they have known about the risks and apparent lack of independence with SPE’s?
What should they have done about it?

a. What are the responsibilities of a company’s board of directors

The board of directors is appointed to act on behalf of the shareholders to run the
day to day affairs of the business. The board are directly accountable to the
shareholders and each year the company will hold an annual general meeting at which
the directors must provide a report to shareholders on the performance of the
company.

b. Could the board of directors at Enron—especially the audit committee—have

prevented the fall of Enron?

It is impossible to know whether BOD of Enron can prevent the fall of this
company since there’s fraud opportunity in this company, that can be seen through:
  Former Chief Audit Executive Enron (Head of internal audit) originally is
Andersen's partner who is appointed as a public accountant of the company.

 Enron's finance director comes from Andersen.

 Most of Enron's accounting staff came from Andersen.

But there’s something that can be done to prevent fraud:

 Establish or adopt audit standards, control quality, ethics, independence and

other standards relating to audits of public companies

 Investigate KAP and its employees, conduct disciplinary hearings, and impose
sanctions if necessary

 Carry out other obligations required to improve professional standards in the

Firm

c. Should they have known about the risks and apparent lack of independence with
SPE’s? What should they have done about it?

In the late 1990’s the company was experiencing unprecedented growth and
leveraged high stock prices in order to enter into a number of transactions known as
“special purpose entities” (SPE’s). With these transactions, Enron received borrowed
loans that appeared as revenue, without any liability on the balance sheet, and were
guaranteed by Enron stock. The company’s board of directors is supposed to act as
shareholder representation and assist with policies and issues. The board of directors
could have taken a further look into the transactions that were occurring to prevent
the fall of Enron. They should have known about the issues with the SPE’s, especially
the amount of transactions including them, and put an end to continued transactions
and make the necessary corrections for the financial reporting.

3. In your own words, summarize how Enron used SPE’s to hide large amounts of company
debt.

Enron created SPE’s (usually other LLP’s) in order to create cash inflow but did
not record the investments and related liabilities (the loans used to create the SPE). Enron
used outside investors to secure the new SPE’s. The new investors would bear the risk of
the investment and Enron used its company stock as collateral to entice the investors and
saying that Enron would basically bear the risk if the investment should turn sour. Enron
used large investment bankers to take loans but these looked more like hedging activities
instead of debt. Once the stock price began to drop, and Enron was losing money, they
were unable to use their stock to cover the losses. To put it simply, a company sells a
product for a stellar price to another entity. However, that entity doesn’t have the cash
 flow to buy the product. So, the seller issues a loan to the buyer in order to sell the
product. Now if the buyer defaults on the loan, the seller loses the cash it lent out and the
product it sold. This is how Enron set up the SPE’s, and they used the large investment
banks to hold the loans that should have been reported on Enron’s balance sheet

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

Issue: Whether or not the auditors can be independent and exercise good professional
judgment when it comes to the audit

Arguments for why auditors should be allowed to perform these services for the same
client include: Auditors can increase audit realization by becoming more efficient during
the external audit since they would be basically auditing their own work.

Arguments for why auditors should not be allowed to perform these services for the same
client include: Auditors may not be able to act independently and may not use the best
professional judgment when performing the external audit.

However, we strongly agree with the statement that auditors should not perform
non-audit services to their clients. According Sarbanes-Oxley-Act, title II consists of nine
sections and establishes standards for external auditor independence, to limit conflicts of
interest. It also addresses new auditor approval requirements, audit partner rotation, and
auditor reporting requirements. It restricts auditing companies from providing non-audit
services (consulting) for the same clients. It is against the act if any auditor fails to obey
these rules. It will be assumed that the auditor lack of independence in issuing the audit
report if provide non-audit services for the same client.

5. Explain how “rules-based” accounting standards differ from “principles-based”

standards. How might fundamentally changing accounting standards from “bright-line”
rules to principle-based standards help prevent another Enron-like fiasco in the future?
Are there dangers in removing “bright-line” rules? What difficulties might be associated
with such a change?

Rule based accounting standards are difference from principle-based standards in

that rule-based standards are just that – rules. Meanwhile Principle based accounting
standards are more like guidelines and can be open to interpretation.

Principle based rules can prevent another Enron-like fiasco because it holds the
accountant and auditors to a higher standard than “just following the code”. Sometimes
the code has loopholes, which is what allowed Enron to create the SPE’s in the first place,
and the company can rely on that. However, if auditors are required to hold themselves to
a higher moral and ethical code, then they may not be swayed by a company’s
 questionable practices, even if they are following the letter of the law. If “bright line”
rules are not relied on at all, and only principle-based rules are followed, then the
interpretation of these principles can cause issues such as aggressive accounting
treatments such as in the Enron case. If there are no hard rules, then companies can say
that the aggressive accounting treatments are not prohibited.

6. Enron and Andersen suffered severe consequences because of their perceived lack of
integrity and damaged reputations. In fact, some people believe the fall of Enron occurred
because of a “run on the bank.” Some argue that Andersen experienced a similar “run on
the bank” as many top clients quickly fired the firm in the wake of Enron’s collapse. Is
the “run on the bank” analogy valid for both firms? Why or why not?

According to the business dictionary, a run on the bank is when individuals

withdraw funds out of fear that it will become insolvent in the near future. When Skilling
blames Enron’s collapse on a classic “run on the bank”, at first glance it seems that this
definition fits what happened at Enron. However, Skilling goes on to say that when
everyone started to back away from Enron, Enron was solvent and highly profitable, just
not liquid enough (Beasly, Buckless, Glover, & Prawitt, 2012). This was not the case
though. George Kaufman, an economist at Loyola University Chicago explains: “The
fable is that a run can bring down a solvent bank. What a run does is: It causes an
insolvent bank to be recognized as insolvent” (Meyerson, 2006, para. 10). This is
important because, while the withdrawals might have expedited the collapse, it was not
the actual cause, as Enron was on its way out already. The fact that Lay sold over 93,000
shares and that Citigroup, JPMorgan Chase, and Dynegy did not go through with
“helping” Enron, shows that they knew Enron was, indeed, insolvent. In the case of
Andersen, this analogy does not work since clients started to drop the firm because they
either felt that the firm was involved in fraudulent activities, or that the mere appearance
would damage their own reputation if they stayed with Andersen. No fear of insolvency
had any part; they just wanted to distance themselves from a firm with a bad reputation.

7. A perceived lack of integrity caused irreparable damage to both Andersen and Enron.
How can you apply the principles learned in this case personally? Generate an example of
how involvement in unethical or illegal activities, or even the appearance of such
involvement, might adversely affect your career. What are the possible consequences
when others question your integrity? What can you do to preserve your reputation
throughout your career?

There are a lot of lessons that one can take away when we look at the Enron and
Andersen case. These include the fact that greed can often lead to people making
irresponsible decisions and personal gain through money should not be the driving force
of how you make decisions. Enron executives personally made millions off of the run-up
in stock price and Andersen retained a $50 million plus client by not reporting the facts.
They did not take their integrity in consideration when committing these acts. If we were
to be involved or perceived to be involved in a situation where we worked for a company
where they were inflating invoices to show higher revenue when the customer was
actually being charged too much, this could adversely affect our career. Even if we were
 not directly involved or knowledgeable of the situation, some may gain the perception
that we are involved and it could lead to our termination and loss of ability to obtain new
employment. When people start to question your integrity, this can cause a snowball
affect where other people begin to do so as well and they no longer trust your work or
terminate your employment. In order to avoid these situations, always present yourself
honestly and avoid situations that may be questionable. The backup of facts or written
documentation can help you to avoid this and knowing when to involve higher levels or a
third party when you discover illegal or unethical behavior is crucial to maintaining
integrity

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

Like any other business accounting firms want to make money. For that purpose,
public accounting firms are concern with making clients happy, providing them with the
outstanding customer service. This is the reason why auditors struggle with making tough
accounting decisions that may be contrary to their client’s position. Auditors don’t want
to upset clients and risk losing money. To keep a good relationship, auditors may not
oppose to the client’s accounting choices, even if it is not following the accounting
standards. A change the profession could make to eliminate these obstacles is to first be
dedicated to the public interest. If the auditor suspects foul play in the financial
statements, it should be reported to management right away. This will help eliminate
difficult decisions, if similar situations occur again, because a guide base is set.

9. What has been done, and what more can be done to restore the public trust in the auditing
profession and in the nation’s financial reporting system?

After the accounting scandal of Enron and Andersen, Congress passed the
Sarbanes-Oxley bill, “to protect investors by improving the accuracy and reliability of
corporate disclosures and changing the way corporate boards deal with their financial
auditors” (Peavler, September 2016). The Public Company Accounting Oversight Board,
PCAOB was created to oversee audits of public companies and broker-dealers, while
protecting investors and the public interest. The PCAOB promotes informative, accurate,
and independent audit reports (About the PCAOB, 2016). To restore, the public trust in
auditing profession and in the nation’s financial system, auditors and companies should
display their dedication to disclosing accurate financial statement.