Government Accounting and Auditing

Crisanto R. Laresma - 1OUMPA626

Prof. Roberto B. Catli

Critical Incident Case

The Enron Scandal

Background

The Enron scandal in October 2001, that led to the bankruptcy of an American energy company - Enron
Corporation and the dissolution of Enron’s audit firm - Arthur Andersen. This event marked as the
largest bankruptcy reorganization in American history at that time and one of the biggest audit failures.

Headquartered in Houston, Enron was an energy, commodities and services company that had
employed close to 22,000 people and had revenues of nearly $101 billion in 2000, shortly before its
downfall.

Enron was formed in 1985 following a merger between Houston Natural Gas and Omaha-based
InterNorth. Kenneth Lay, who had been the chief executive officer (CEO) of Houston Natural Gas,
became Enron's CEO and chairman, and quickly rebranded Enron into an energy trader and supplier.
Deregulation of the energy markets allowed companies to place bets on future prices, and Enron was
poised to take advantage.

By 1993, Enron had set up a number of limited liability special purpose entities that allowed Enron to
hide its liabilities while growing its stock price. Analysts were already criticizing Enron for "swimming
in debt," but the company continued to grow developing a large network of natural gas pipelines, and
eventually moving into the pulp and paper and water sectors. Enron was named "America's Most
Innovative Company" by Fortune for six consecutive years between 1996 and 2001.

Facts of the Case

Misleading Financial Accounts

Creative accounting allowed Enron to appear more powerful on paper than it really was. Special
purpose entities – subsidiaries that have a single purpose and that did not need to be included in Enron's
balance sheet – were used to hide risky investment activities and financial losses. Forensic accounting
later determined that many of Enron's recorded assets and profits were inflated, and in some cases,
completely fraudulent and nonexistent. Some of the company's debts and losses were recorded in
offshore entities, remaining absent from Enron's financial statements.

During the late 1990s and into the early 2000s, more and more special purpose vehicles were created
that allowed the company to keep debts off the books and inflate assets. These entities, along with other
accounting loopholes and poor financial reporting, let Enron ultimately hide billions in debt from
special deals and projects.

Sell-Off
In August of 2001, shortly after the company achieved $100 billion in revenues, then-CEO Jeff Skilling
unexpectedly resigned, prompting Wall Street to question the health of the company. Kenneth Lay once
again took the helm, and both Lay and Skilling, in addition to other Enron executives, began selling
large amounts of Enron stock as prices continued to drop – from a high of about $90.00 per share
earlier in the year, to less than a dollar. The U.S. Securities and Exchange Commission (SEC) opened
an investigation.

Less than a week after a white knight takeover bid from Dynegy was called off, Enron filed for
bankruptcy protection. The company had more than $38 billion in outstanding debts. In the following
months, the U.S. Justice Department initiated a criminal investigation into Enron's bankruptcy. Several
Enron executives and Enron's auditor firm, Arthur Andersen, have since been indicted for a variety of
charges including obstruction of justice for shredding documents and conspiracy to commit wire and
securities fraud, and some have been sentenced to prison.

Aftermath
Enron's collapse, and the financial havoc it wreaked on its shareholders and employees, led to new
regulations and legislation to promote the accuracy of financial reporting for publicly held companies.
In July of 2002, President Bush signed into law the Sarbanes-Oxley Act, intended to "enhance
corporate responsibility, enhance financial disclosures and combat corporate and accounting fraud."

The Act heightened the consequences for destroying, altering or fabricating financial records, and for
trying to defraud shareholders.

Once Enron's Plan of Reorganization was approved by the U.S. Bankruptcy Court, the new board of
directors changed Enron's name to Enron Creditors Recovery Corp to reflect its sole mission: "to
reorganize and liquidate certain of the operations and assets of the 'pre-bankruptcy' Enron for the
benefit of creditors." The board wishes to "obtain the highest value from the company's remaining
assets and distribute the proceeds to the company's creditors." After the corporation has finalized
"outstanding litigation and monetized all of assets, it will make a final distribution to creditors," and the
company "will cease to exist."

At the time of Enron's collapse, it was the biggest corporate bankruptcy ever to hit the financial world.
Since then WorldCom, Lehman Brothers and Washington Mutual have surpassed Enron as the largest
corporate bankruptcies. The Enron scandal drew attention to accounting and corporate fraud, as its
shareholders lost $74 billion in the four years leading up to its bankruptcy, and its employees lost
billions in pension benefits. The Sarbanes-Oxley Act has been called a "mirror image of Enron: the
company's perceived corporate governance failings are matched virtually point for point in the
principal provisions of the Act." Increased regulation and oversight have been enacted to help prevent
or eliminate corporate scandals of Enron's magnitude.

Possible Solutions

1. Reforming both financial statement auditing and other aspects of the financial reporting system.
Procedural reforms must therefore go hand-in-hand with fundamental reforms that change the
incentives dynamics.
2. Research and development into sophisticated fraud detection techniques should be stimulated,
and auditors should show a renewed interest, in the course of the statutory audit, in more subtle
issues of accurate economic valuation techniques.
3. Enactment of a Reform Bill. As with the Enron experience and subsequent scandals involving
 much bigger companies, Sarbanes – Oxley Act of 2002 was passed to set new or enhanced
standards for all U.S. public company boards, management and public accounting firms. One of
the salient features of the law is the change in the power to hire and fire an auditor. The easiest
way to change the incentives that auditors operate under is to change who hires them to an
entity that is interested in improving the client company’s information quality. Sarbanes-Oxley
removes the power to hire and fire the auditor from the executive and gives it to an independent
audit committee.

Potential Problems to the solutions

1. There are deep cultural and institutional barriers that concerns changing (e.g. mindsets and
incentives system). Specific audit reforms that might be a good idea in principle may fail in the
implementation if auditors are unable or unwilling to take their responsibility to find fraud
seriously. Because cultural attitudes take a while to change, real reform will not happen
overnight.
2. In terms of research and development, additional investment would entail additional social cost
for the project. In the Philippines this could take some time in terms of the budget and the
political environment with rampant graft and corrupt practices that collides with the biggest
corporate frauds, so as to answer the question of cost-benefit analysis would challenge the
uncovering first the magnitude of this collusion between the company, the “guardians” and
other regulatory and enforcing agencies that might have been involved.
3. There are legitimate questions about the narrow cost-benefit calculation of the non-audit service
restrictions prescribed in the law. Real benefits are foregone with the restrictions, and the
banning of some non-audit services to audit clients is unlikely to be a panacea. But it is difficult
to see, given the deep-rooted resistance within the profession, to accepting responsibility to
view their clients’ representations with skepticism that allowing unlimited non-audit services
will not hinder the cultural shift necessary to make auditors effective monitors.
4. The most contentiously debated portion of Sarbanes-Oxley is the Section 404 requirements that
companies document their internal controls and that auditors audit them. In the first years that
Section 404 has been implemented, auditors have done exhaustive tests of most of the controls
of each of their clients, down to those of the pettiest transactions. Businesses have complained
that the approach is completely unbalanced and inefficient. Furthermore, it is not clear that
auditors are not testing minor controls to the exclusion of the ones that actually matter—such as
that affecting upper-level management.

References

1. Wikepedia. Enron Scandal. http://en.wikipedia.org/wiki/Enron_scandal

2. William B. Bratton. “Enron and the Dark Side of Shareholder Value”. Tulane Law Review, May
2002, Forthcoming http://papers.ssrn.com/sol3/papers.cfm?abstract_id=301475
3. ADAM LASHINSKY. “Bankrupt Analysis “. NY Times.com 2001
http://whatreallyhappened.com/WRHARTICLES/enron.html
4. Wikepedia. Public Accounting Oversight Board.
http://en.wikipedia.org/wiki/Public_Company_Accounting_Oversight_Board
5. Wikepedia. Sarbanes – Oxley Act . http://en.wikipedia.org/wiki/Sarbanes
%E2%80%93Oxley_Act
6. Sarbanes – Oxley Act of 2002. https://www.sec.gov/about/laws/soa2002.pdf
7. Abigail Bugbee Brown.(2006) “Private Firms Working in the Public Interest”.(Doctoral
Dissertation)Retrieved from www.rand.org