7 case 4] Enron Corporation and Andersen, LLP Analyzing the Fall of Two Giants MARK S, BEASLEY FRANK A. BUCKLESS - STEVEN M. Grover: Douctas F. Prawtr LEARNING OBJECTIVES ‘After completing and discussing this ease you should be able to {11 Understand the events leading to Enron's {51 Understand the difference between “rule-based” bankruptey and Andersen's downfall and “principle-based” accounting standards to (2) Appreciate the importance of understanding an better appreciate some of the issues involved in tet clicoPscors budlaess strategies the movement toward international financial [5] Recognize potential conflicts arising from seporting exndarde (IFES). auditor relationships with their clients {51 Consider challenges facing the accounting profession and evaluate alternative courses of action for overcoming these obstacles {41 Understand how accounting standards may hav contributed to the Enron debacle and describe how some in the accounting profession are secking to change the fundamental nature of those standards INTRODUCTION Enron Corporation entered 2001 as the seventh largest public company in the United States, only to later exit the year as the largest company to ever declare bankruptcy in U.S history. Investors who lost millions and lawmakers seeking to prevent similar reoccurrences were shocked by these unbelievable events. The following testimony of Rep. Richard H. Baker, chair of the House Capital : ‘Markets Subcommittee, exemplified these feelings: 3 We are here today to examine and begin the process of understanding the most stunning business reversal in recent history. One moment an international corporation with a i diversified portfolio enjoying an incredible run-up of stock prices, the darling of financial ppress and analysts, which, by the way, contributed to the view that Enron had indeed iseconse the new model for business of the future, indeed, a new paradigm. One edition of Fortune magazine called it the best place in America for an employee to work, Analysts ‘gave increasingly creative praise, while stock prices soared... Now in retrospect it is clear, at least fo me, that while Enron executives were having fun, it actually became a very large hedge fund, which just happened to own a power company. While that in itself does not warrant criticism, it was the extraordinary risk-taking by powerful executives which rarely added value but simply accelerated the cash burn-off rate. Executives having Enron fun are apparently very costly and, all the while, they were aggressive in the exercise of their own [Enron] stock options, flipping acquisitions for quick sale. One executive sold a total i of $353 million in the 3-year period preceding the failure. What did he know? When did Ihe know it? And why didn’t we?! rn Tap Ricard Baker (RA), 2001 Hearing ofthe Capt Maas Insurance and Goverment sponsored enterprise sucommites ‘doneaaghtandinveatonsubeommite ofthe Hou Finch Seeces Comte, “The Eazon Calpe: uct on investors and Finan Mackete™ rhe cave wns prepared by Mar Beasley, Ph.D and Frank A. Backes, PRD. of North Carolina State Univesity an Steven M. Glover PhD. and Dowgla Petwite PRD. of Brigham Young Univers ar basis fr clas discussion. Its not intended tls either effective or nective Iandling of sn adnstratve sition. Copyright © 2012 by Porson Education, In, Upper Sule Rive, 1U 7458 15Section 4: Accounting Fraud ond Auditor Legal Liability ‘Although company executives were involved in questionable business practices and even Enron's failure was ultimately due to a collapse of investor, custome and trading partner confidence. In the boom years of the late 1990's, Enron ‘entered into a number of aggressive Cotnsactions involving “special purpose entities” (SPEs) for which the underlying accounting twas questionable or fraudulent. Some of these transactions essentially involved Enron receiving tee ave funds without recording liabilities on the company's balanes sheet. Instead, the inflow ae rrovde was made to look like it came from the sale of assets, The “Joans” were guaranteed with Enron stock, trading at over $100 per share at the time, The company found itself in real trouble ‘when, simultaneously, the business deals underlying these transactions ‘went sourand Enron's stock price plummeted. Debt holders began to call the Teans due to Enron’s diminished stock price, and he company found its accounting positions increasingly problematic to maintain. ‘The August 2001 resignation ‘of Enron's chief executive officer (CEO), Jeffrey Skilling, only sixmonths after beginning his “dream job” further fueled Wall Street skepticism and scrutiny over Company operations. Shortly thereafter, The Wall Street ‘Journal's “Heard on the Street” column of ‘August 28, 2001 drew further attention to the company, ‘igniting a public firestorm of controversy that quickly undermined the company’s reputation. The subsequent loss of confidence by trading partners and customers quickly dried up Enron’ ‘ading volume, and the company found itself facing a liquidity crisis by late 2001 Skilling summed it up thi ‘Committee on February 7, 200 It is my belief that Enron's failure was due toa classi ‘run on the bank:’ a liquidity crisis spurred bya lack of confidence inthe company. Atthe tine of Enron's collapse, the company ar rolvent and highly profitable - but, apparently, not liquid enough. That is my view of i the principal cause of its failure? Public disclosure of diminishing liqui practices destroyed the trust Enron had estab Pandreds of trading partners, clients, and supp ultimately leading to its downfall A eae pe, along with events related tothe audits of Baron's fnancta!staten sis, caused a similas loss of reputation, trust, and confidence in Big-S accounting firm, ‘Andersen, LLP. Enron's aGllapse and the associated revelations of alleged aggressive and inappropri tt accounting practices ceaP eS aajor damage for this previously acclaimed firm. News bodt charges of inappropriate sree Tok of documents at the Andersen office in Houston, which housed the Enron audit, esr the subsequent unprecedented federal indictment was the kiss of death. Andersen's clients Gquiekly lost confidence inthe firm, and by June 2002, mors than 400 of its largest clients had fired see tea as their auditor, leading to the sale or desertion of various pieess of Andersen's U.S. and International practices. On June 15°, a federal jury in Houston convicted Andersen on one felony interna cracting the SEC’ investigation into Enron's collapse. Although the Supreme Court cart vestucned the decision in May 2005, the reversal came nearly three Years after Andersen was ‘esentially dead. Soon after the June 15, 2002 verdict, Andersen ‘announced it would cease auditing publicly owned clients by August 31. Thus like Enron, ino” ‘astonishingly short period of time dean owet from being one ofthe world largest and most respected business organizaions into oblivion. Because ofthe Congressional hearingsandintensemedia coverage, alongwith the tremendous omy on the corporate community and on the accounting profession, ‘Here is a brief analysis of the fall of these fraud, ‘way when he testified before the House Energy Commerce ‘dity and questionable management decisions and lished within the business community. This caused Tiers to suspend doing business with the company— | i ; impact the company’s collapse k the name “Enron” will reverberate for decades to come. two giants. ee [Rang ety," Prepard Wines Testimony Sling Jt, X7 Howse Bows) teioiare See the following website: sania pyeommerce noe go/ 07 estngs/ O2072002Hearing$85/Skiing?27-ni IbCase 4.1: Enron Corporation ond Andersen, LLP ENRON IN THE BEGINNING Enron Corporation, based in Houston, Texas, was formed as the result of the July 1985 merger of Houston Natural Gas and InterNorth of Omaha, Nebraska. In its early years, Enron was a natural g88 pipeline company whose primary business strategy involved entering into contracts to deliver specified amounts of natural gas to businesses or utilities over a given period of time. In 1989, Enron began trading natural gas commodities. After the deregulation of the electrical power markets in the early 1990s—a change for which senior Enron officials lobbied heavily—Enron swiftly evolved from a conventional business that simply delivered energy, into a “new economy” business heavily involved in the brokerage of speculative energy futures. Enron acted as an intermediary by entering into contracts with buyers and sellers of energy, profiting by arbitraging price differences. Enron began marketing electricity in the U.S. in 1994, and entered the European energy market in 1995. In 1999, at the height of the Internet boom, Enron furthered its transformation into a “new economy” company by launching Enron Online, a Web-based commodity trading site. Enron also broadened its technological reach by entering the business of buying and selling access to high-speed Internet bandwidth. Atits peak, Enron owned a stake in nearly 30,000 miles of gas pipelines, owned or had access to a 15,000-mile fiber optic network, and had a stake in several electricity-generating operations around the world. In 2000, the company reported gross revenues of $101 billion. Enron continued to expand its business into extremely complex ventures by offering a wide variety of financial hedges and contracts to customers. These financial instruments were designed to protect customers against a variety of risks, including events such as changes in interest rates and variations in weather patterns. The volume of transactions involving these “new economy" type instruments grew rapidly and actually surpassed the volume of Enron’ traditional contracts involving delivery of physical commodities (such as natural gas) to customers, To ensure that Enron managed the risks related to these “new economy” instruments, the company hired a large number of experts in the fields of actuarial science, mathematics, physics, meteorology, and economics.> Within a year of its launch, Enron Online was handling more than $1 billion in transactions daily, The website was much more than a place for buyers and sellers of various commodities to meet. Internetweek reported that, “It was the market, a place where everyone in the gas and power industries gathered pricing data for virtually every deal they made, regardless of whether they executed them on the site."’ The site's success depended on cutting-edge technology and more importantly on the trust the company developed with its customers and partners who expected Enron to follow through on its price and delivery promises. When the company’s accounting shenanigans were brought to light, customers, investors, and other partners ceased trading through the energy giant when they lost confidence in Enron’s ability to fulfill its obligations and act with integrity in the marketplace.’ ENRON’S COLLAPSE ‘On August 14, 2001, Kenneth Lay was reinstated as Enron's CEO after Jeffrey Skilling resigned for “purely personal” reasons after having served for only a six-month period as CEO. Skilling joined Enron in 1990 after leading McKinsey & Company's energy and chemical consulting practice and became Enron's president and chief operating officer in 1996. Skilling was appointed CEO in early 2001 to replace Lay, who had served as chairman and CEO since 1986.° 3. “Understanding Enron: Rising Power” The Washington Post. May 11,2002, See the fllowing website http://wwwcvashingtonpostcomy/ wp-srv/business/enron front html 4 Peestoa, Robert. “Enron Demise Doest!t Devalue Model It Create Int S Ibid {6 “The Rise and Fall of Enron: The Financial Players” The Washington Post. May 11, 2002, Sse the flowing website: htp//wwwcvashingtonpostcomy/ wp-srv/business/aily/articles/keypl netwerk: December 10,2001 rs_financal tm 7(Section 4 Acouting Fra and Auditor Logel Lichlity Saling’s resignation proved to be the beginning: of Enron's collapse. The day after Skilling resigned, Enron's vice president ‘of corporate development, Sherron ‘Watkins, sent an anonymous ‘esignes kenneth Lay (see Exhibit 1), Inthe lettes) Ms, ‘Watkins detailed her fears that Enron “might implode in a wave of accounting scandals” When the letter later became public, Ms. Watkins was celebrated as an honest and loyal ‘employee who tried to save the company through her whistle- lowing efforts. r EXHIBIT 1: SHERRON WATKINS LETTER TO ENRON CEO, KENNETH LAY Dear Mr Lay, tas Enron become a sky lace 10 work? For thse of us who cian gt ich over the last few years, can we ard to stay? ‘lings abrupt departure wil ese suspicions of accor). impropritis and vation issues, Enron has Deen SY gressive nts accourting ~ mast sab the Rape ‘rng amione and the Condor vehi. We do have valuation ae ith our miernaboral asses and possibly some of our ‘EES MTM postions. “ho spight wl be onus, he markt tar accept ecion 4 Acounting Froud and Auditor Leg Liability ttalso appears that Andersen knew about Enron's problems nearly a year before the downfall, ‘According to a February 6, 2001 dnternal firm e-mail, Andersen Considered dropping Enron as @ Ghent. The e-mail, which was written iby an Andersen partner to David Duns partner in charge the Enron audit, detailed the discussio™ sen Andersen meeting about the Futare of the Enron engagement. The essential text Sf that email is reproduced in Exhibit 3- The Andersen Indictment ‘Mitkough the massive restatements of ENIOT financial statements cast serious doubt on Andersen's A palcontcrand at nT thedestruction ofEnron-related documen!s Pe eteber and November 2001 and the Naech 2002 federal indictment of Andesien that led to the frem’s rapid downward spiral. The ane ynal charge against Andersen related fo the obstruction of justice for destroying documents «er the federal investigation had begun Int the Enron collapse. recording to the indictment, Andersen allegedly eliminated potentially incriminating evidence BY Shredding massive amounts of nuderstelated audit workpapets and document. “The government STleged that Andersen partners in Honstve sce directed by the firms national offic Jegal counsel in ‘Chisago to shred the documents. The {58, Justice Department contended that "Andersen continued to shred Enron documents after it seesvof the SEC investigation, but before 2 formal subpoena was IS sewved by Andersen. The shredding stopped on November 8 when “Andersen received the SECS subpoena for all Enron-telated docums0™, na er nen denied that its corporate cOunse] recommended sucha course factionand assigned the blame for the document destruction 192 £000 of rogue employees in its Houston office seeking sree their own reputations. The evidence enaear as to exactly who ordered the shredding of the Teena documents or even what documents "TE shredded. sewer, central to the Justice Deparementt t dictment was an email forwarded from Nancy Temple, Andersen's comporare Counsel in Chicago, to David Duncan, the Houston-based anon engagement partner. The body of The email states, “It might be useful fo consider reminding the engagement team of our document ato ord retention policy. 1t willbe helpful te ‘make sure that we have complied withthe policy. Let me Know if you have any questions.” “rhe Justice Department argued that sKndersen’s general counsel's email was 2 thinly veiled irective from Andersen headquarters 19 7° ‘hat all Hnron-related documents that should have previously been destroyed vclording to the firm’s policy were destroyed. Andersen contended rer the infamous Nancy ‘Temple meno “imply encouraged adherence to normal engagement “Jocumentation policy, including the explicit need to retain documents ip tertain situations and was sever intended fo obstruct the governments investigation. Howes itis important to understand mea snce an individual ofa firm has reason iene that a federal investigation is forthcom™Bs itis wnat dered “obstruction of justice” to destroy rigcuments that might serve as evidence, eve? before {an official subpoena is filed. in January 2002, Andersen fired Eason engagement partner David Duncans for his role in the document shredding activities Dunean later testified that he did not initially think that what he ares aoas wrong and initially maintained Bis iaocence in interviews with government prosecutors. He even signed a joint defense agreement ints Andersen on March 20, 2002. Shortly thereafter, Bt pean decided to plead guilty to obstructn fjustice charges after ‘a Tat of oul searching about my rt and what was in miy ead at the tre fat Ta the obstruction of justice trial agains’ ‘Andersen, Duncan testified for the Federal prosecution, admitting that he ssrdered the destruction of documents tpecause of the email he Prose from Andersen's counsel reminding vier of the company’s document retention policy. He reccieifed that he wanted to get rid of ne Jaments that could be used by prosecullns attorneys ‘and SEC investigators.” Sp Toasle Nancy A-Emalo Michel C. Odom DOPE Retention Policy” October 12, 2002 20 Tee Ln, eal Rogers and Bret Gating eno My Mind eanncom. Ny 15 2002 She following Bea tp /moneyenn-com/ 2002/05/18 [neo co/andersen/index htm sy Wh ute, Ales Barionaev. “Duncan Sas ea pea ge Sheng” The Wall strc Journal New oACase 4.1: Enron Corporation and Andersen, LP EXHIBIT 3: INTERNAL ANDERSEN EMAIL ON ENRON From: Michael D. Jones, Houston, 2541 Sent Tuesday, February 6, 2001 08:24 AM To: David B. Duncan@ANDERSEN WO, Thomas H Baver@ANDERSEN WO Subject: Enron retention meeting ‘ave was no sure whether you wer planning on documenting he meeting yesterday. My significant nots were as flows (these were no very deed, but | was nt sure how detaed you wand o gat, assuming thal you were going to document the ‘meeting. Let me know if you want mf ake asl a it fist (i 0 we shoud probably gat together for afew minutes to cscuss your documentation dea). ‘Atendees: By Phone: Samak, Swanson, Jneaux, Jonas, Kutsenda, Stewart In Houston: Bennet, Goddard, Goolsby, Odom, Lowther, Duncan, Baver, Jones, Slgnican cicussion was held regarding the relaed pary transactions wih LIM icufng the mately of such amounts to Enron's income statement and the amount retained “off balance sheet.” The discussion focused on Fasiow’s conics of inerest inis capacity as CFO and the LIM fund manager, the amount o earrings that Faslow receives fr his services and parcpation in LIM, he discloses o the transactions in the nancial fotnaes, Enron's BOO's views regarding he ransactions and our ‘and managements commuricaton of such transaction othe BOD ard our testing of such ansactions to ensue that we ly understand the economics and substance ofthe ransacton, ‘The queston was ised as whether the BOD gels any competing bids when the company execules vansactons wth LIM. DBD tepled that he cd nt belive so, but explained tei ransacon approval process genealy and speccaly related to LIM transactions. ‘A sigiicantescusion was also held regarcng Enron's MTM earings and the fact that twas “inteligent gambling” We ‘discussed Enon risk management actives including thot iis, valuation and poston moritering, We discussed Envo's race ons curent relating to mainizn tse a high cre rated transaction pay We discussed Enron's dependence on transaction execton to mee financial objctives, the fact that Enron often is eating industes and mares and tansacons lor wich there are no species which reques significant judgement and that Ervon is aggressivein ts transaction stucturing, We discussed consultation among the engagement team, wih Houston management, ‘pracce management and the PSG to ensure thal we are not making decisions in isolation, ‘Utmataly the conclusion was reached lo retain Emon a a cent cing that t appeared that we had the appropiate people ‘and processes in pace to serve Enron and manage out engagement sks. We discussed whether there would be a perceived independence issue solely considering our level a fees, We discussed thatthe concerns shoud not be on the magnitude o fees buton the nature of fes. We abiarly dscussed that woul not be unforseeabe that fes could reach a $100 milion per year ‘amount considering the mul-ciciplnary services being provided. Such amount didnot wouble the participants as long asthe nature ofthe services was not an issue. {In adion tothe above, discussions were held to varying degres on each page ofthe presentation materi. Take anay To Dos: Inuite 2s to whether Andy Fastow and /or LIM woul be viewed as an aia” rom an SEC perspective which woud require locking through the transactions and treating them as wiin the consolidated group. ‘Suggest tha special commits ofthe BOD be estabished to review the faimess of LIM transactions (ratamatve comlo that the Wansactons ae far to Enron, e.9., competitive biesng) Why did Andy not select AA as auditors, ncuding when PWC was replaced with KPMG. Discussions concluded thal we would ‘ely not want to be LIM's rancial advisors given potential conc of interest with Enron Focus on Enron preparing ther an documentation and concusions to issues and transaction. ‘AA o focus on timely ocumentaton of final ansacton structures to ensure consensus is reached onthe final suture (©2001 Artur Andersen. Al ights Reserved, Dav, Duncan 85~ Section 4: Accounting Fraud ‘and Auditor Legal Liability by appe: Court ref claimed that the trial judge “Although convicted of o in shredding documents related ton May 31, 2005, the Court overturned the lower ¢ Supreme Court's decision had little effect on the fi Sadly, the 2005, Andersen employed only lawsuits against the ed individual Arthur Ander help rai ore difficult forthe government to pursue ful have mat against in The End of Andersen In the early months of 2002, duals and compan other four Big-5 accounting fir & Touche. The most serio ‘Andersen partnerships by D anouncement of the acquisition was schedul of Andersen apparent and responsibility for sett Hn the aftermath of Enron's coll publicly traded clients by Ju had enjoyed long relationship: SunTrust Banks, clients, Andersen lost agreed to sell a major por ge most of its tax advisory practice ‘On March 26, 2002, Josep! remained with the fir chairman, Paul Volcker, Mr. Volcker and the boat and that Volcker an¢ and to implement reforms. ‘stave off criminal charges a ‘wade the justice department to wi in April 2002. "Andersen faced an uphill count for obstruction of justice, the USS. financial system has ‘Andersen would not likely hav f obstruction of justice on June 15, tment of a gross abuse the firm ceased to audit publi to perst to rebuild the firm single count o} the justice depart the conviction. However, ah ‘May 1, 2002. 23 Bravin, Jes. "Justices Overturn 2A Luke, Robert “Andersen Explores sting the verdict to the Fifth US. Circuit Court ® fused to overturn the verdict, 0 ‘Andersen appes “gave jurors poor gui {o Enron Corp. The Supreme Court agrees sourt's decision. ine 2002—inch 15.4 The list of Freddie Mac, and Valero Energy ‘ many ofits global practice units to rival counting 2 tion of ts consulting business to ‘abbott Laboratories, ‘m, In an attempt to head an oversight b 1rd recommended that Andersen rd the seven-member board take over Andersen it oF "The success of the oversigh ind settle lawsuits related to it ithdraw its charges, Mr. Vole Jpstruction of justice, Ander ‘200 people, most of whom fim and managing its few remaining civil suits named against th sen partner: ies. “Andersen pursued the possibil ‘ms: PricewaterhouseCoopers, Exnst & Young, wsly considered possibility was eloitte & Touche, but the talks led to take place. The biggest barrier iy centered around fears that an aca ling future Enron-related lawsuits. lapse, Andersen began to unravel qi jading many high to Deloitte & Touche. regardless of the trials re been the first, even ha 2002. Criminal Verdict in Andersen Case” “Office Shifts in Atlanta” The Ate saled to the U.S. Suprem r rekines for determining the company’s wrongdoing .d with Andersen and hh Berardino, CEO of An‘ to salvage the firm, Ander yoard to make recommendation: ‘a major financial-services of governmental p sen continued to pursue legal ‘were invol wuirer would assume Ar split its cor "Andersen, along with many others, icly held clients by August 31, 2002. Wall tre Journal, New York. May 31,2005. ta Journal Constitution, May 18,2002 J recourse f Appeals in New Orleans. The Fifth e Court. The firm. fature of Arthur Andersen. By Jved in fighting the remaining Nssets, However, the ruling may have fem. The ruling also may ture cases alleging obstruction of justice lity of being acquired by one of the KPMG, and Deloitte am acquisition of the entire collection of {all through only hours before an official to an acquisition ndersen's liabilities yuickly, losing over 400 profile clients with which Andersen ene clients includes Delta Air Lines, FedEx, Merck, Corp. In addition to losing 4 consulting firms, and KPMG consulting for $284 million as well dersen Worldwide, resigned as CEO, sen hired former Federal Reserve s to rebuild Andersen. rngulting and auditing businesses der to realign firm management * board depended on Andersen’ ability to fe work on Enron, Because Andersen failed cer suspended the board's efforts ‘pate ints fight against the federal prosecutors’ charges ofa felony ‘outcome. Never in the 215-year history of firm survived a criminal indictment, and dd the firm not actually been convicted of a accused wer, and announced that it would appeal Latatnatnansnnehins aeCase 4.1: Enron Corporation and Andersen, LLP REQUIRED 1 io) (31 (41 15) (6) rm fal io} What were the business risks Enron faced, and how did those risks increase the likelihood of material misstatements in Enron's financial statements? (a) What are the responsibilities of a company’s board of directors? (b) Could the board of directors at Enton—especially the audit committee—have prevented the fall of Enron? (c) Should they have known about the risks and apparent lack of independence with Enron's SPEs? What should they have done about it? In your own words, summarize how Enron used SPEs to hide large amounts of company debt. 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. What is your view, and why? Explain how “rule-based” accounting standards differ from “principle-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? Some argue that the trend toward adoption of international accounting standards represents a move toward more “principle- based” standards. Are there dangers in removing “bright-line” rules? What difficulties might be associated with such a change? 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 form of “run on the bank” Some argue that Andersen experienced a similar “run on the bank” as many top clients quickly dropped the firm in the wake of Enron's collapse. Is the “run on the bank” analogy valid for both firms? Why or why not? ‘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 affect your career. What are the possible consequences when others question your integrity? What can you do to preserve your reputation throughout your career? Why do audit partners struggle with making tough accounting decisions that may be contrary to their client's position on an issue? What changes should the profession make to eliminate these obstacles? What has been done, and what more do you believe should be done to restore the public trust in the auditing profession and in the nation’s financial reporting system? 87