HI6026 AUDIT, ASSURANCE AND COMPLIANCE

1. LESSON FROM ENRON SCANDAL:

The history of Enron and Arthur Andersen reveals a very simple story. Approximately 10 years
ago, the truth emerged about Enron, one of the largest and seemingly most successful energy
companies in the world until it collapsed and declared bankruptcy. What happened at Enron was
due primarily to the ethical climate in business at the time. Improper accounting practices still
occurred, and audit firms either could not or would not stop them- or even report them once
discovered. The environment poses challenges to organizations and managers need to
understand and interpret these challenges in order to determine an appropriate response. This
is critical for the organization under conditions of both stability and change, since their initial and
continued existence depends, to a great degree, on its response to those contexts. The Enron
case proves, to the international investor community, that there are uncertainties in the whole
system.

Do not Invest in What You Cannot Understand

Enron had a very complicated business model that many investors did not fully understand. In
fact, Warren Buffett – literally the most successful investor ever – claimed that even he did not
understand some of the transactions described in Enron’s financial statements.

“Never invest in any company before you’ve done the homework on the company’s earnings
prospects, financial condition, competitive position, plans for expansion, and so forth.” – Peter
Lynch

Enron’s firmly optimistic outlook for future growth was dramatically different from what actually
materialized for the company’s investors. Personally, I find the company’s use of the phrase ‘at
minimum’ particularly troubling. This underscores the risk of blindly believing corporate growth
forecasts. Enron’s complicated business model and excessive growth forecasting contributed to
the company’s eventual downfall. These two characteristics should be viewed as red flag in
potential stock market investments.

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Beware of Excessive Leverage

Enron’s excessive amount of leverage magnified its poor financial performance. The easiest way
to demonstrate Enron’s excessive leverage pre-bankruptcy is to compare its current balance
sheet composition to today’s energy giants. The Liabilities and Shareholders’ Equity section of
Enron’s year-end balance sheet for fiscal 2000 can be seen below:

Source: Enron 2000 Annual Report, page 33

Enron reported shareholders’ equity of $11.5 billion and total liabilities and shareholders’ equity
of $65.5 billion. A quick difference calculation gives total liabilities of $54 billion. Some additional
quick math shows that Enron had a debt-to-equity ratio of 4.7x (computed as $54 billion of total
liabilities divided by $11.5 billion of total shareholders’ equity).

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Enron’s expensive debt combined with its highly volatile business model combined to create
excessive losses for the company’s investors. When analyzing a company’s balance sheet,
prospective investors should keep these two factors in mind.

Understand and Assess Counterparty Risk

Enron’s shareholders were not the only ones who were significantly harmed by the Enron
scandal. Many of the company’s counterparties also suffered extreme financial losses. By and
large, this is because they did not properly assess the counterparty risk that they assumed when
entering agreements with Enron. Counterparty risk is defined as:

“The risk to each party of a contract that the counterparty will not live up to its contractual
obligations. Counterparty risk is a risk to both parties and should be considered when evaluating
a contract.” – Investopedia

There are many different types of counterparties that suffered financial losses after the Enron
scandal. Many of them were on the other end of the many derivative contracts held by Enron at
the time of its bankruptcy. Derivative counterparties and lenders aside, there is one notable
Enron counterparty whose bankruptcy-related financial distress is still widely remembered to this
day. I am referring to the accounting firm Arthur Anderson, which was hired to be Enron’s official
auditor. At the time of the Enron scandal, Arthur Anderson was one of the five largest accounting
firms in the United States and had a robust reputation for high operating standards and quality
risk management. In fact, the involvement of Arthur Anderson in Enron’s accounting was seen as
a vote of confidence among many market participants who were skeptical of the accuracy of
Enron’s financial statements. However, the company did not live up to its reputation. Its
involvement in Enron’s accounting fraud is undisputed. Arthur Anderson did not fulfil his duties
under the code of ethics and responsibility and he did not reveal the material misstatements
present in financial statement. An auditor has to be independent physically and psychologically
while issuing ‘true and fair’ report, but this was not the case with Arthur Anderson.

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The Importance of Management Integrity Cannot Be Understated

It is hard to overstate the importance of having high-quality management at the helms of the
businesses that we invest in. Outstanding managers with great capital allocation skills and a laser-
sharp focus on building shareholder value have tremendous potential to deliver market-crushing
total returns over long periods of time. Conversely, bad managers produce unsurprisingly bad
results. Enron is a very extreme example of this. Truthfully, it can be difficult as an individual
investor to gain any insight into the quality of corporate boardrooms. Three major tools that
investors can use to monitor the performance of their executives (even from a distance). I’ll
briefly explain each tool and then discuss how it could have been usefully applied prior to the
Enron bankruptcy.

The first is quarterly investor conference calls. These calls are when executives discuss ongoing
corporate events and financial performance with analysts and sometimes large shareholders. The
executive’s tone, transparency, and willingness to answer hard questions on these calls is a rough
yardstick to measure management’s commitment to building value for shareholders. The next
tool for assessing management’s true intentions is insider trading transactions. The last source
that investors can use to monitor the executives of their investees is the broader news media.
Generally speaking, poor behavior reported in the media may indicate underlying problems at
the executive level.

2. AUDITORS RESPONSIBILTY TO ADDRESS MATERIAL MISSTATEMENT:

In order to avoid another Enron, it is crucial to implement new rules and regulation under APES
110 to make auditor more responsible and liable in case of failure to point out material
misstatement. Traditional financial statement auditing begins with an auditor assessing a
company’s internal control environment, the processes used to promote reliability of a
company’s financial reporting. Relative control effectiveness dictates the scope of substantive
testing auditors apply to financial statement assertions. Traditionally, auditing standards did not

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require auditors to disclose to financial statement users the details of their control assessment
process or its effect on the scope of substantive testing they performed. As a matter of law, this
meant that auditors faced no liability to financial statement users for failure to disclose control
irregularities or those effects. It also meant, when giving an opinion on financial statement
assertions, that auditors are secondary actors, not liable to financial statement users defrauded
through materially misstated financial statements. The wave of financial statement frauds of the
late 1990s and early 2000s exposed shortcomings of this traditional approach to auditing and
related auditor legal liability.
APES 110 aims to have the auditor’s consideration of fraud seamlessly blended into the audit
process and continually updated until the audit’s completion. It describes a process in which the
auditor gathers information needed to identify risks of material misstatement due to fraud,
assesses risks after taking into account an evaluation of the entity’s programs and controls and
responds to the results. Under APES 110, the auditors will gather and consider much more
information to assess fraud risks than they had in the past.

PROFESSIONAL SKEPTICISM
Auditors need to overcome some natural tendencies such as overreliance on client
representations and biases and approach the audit with a skeptical attitude and questioning
mind. Also, the auditor must set aside past relationships and not assume that all clients are
honest. The new standard provides suggestions on how auditors can learn how to adopt a more
critical, skeptical mind-set on their engagements, particularly during audit planning and the
evaluation of audit evidence.

DISCUSSION AMONG ENGAGEMENT PERSONNEL

APES 110 requires the audit team to discuss the potential for a material misstatement in the
financial statements due to fraud before and during the information-gathering process. This
required “brainstorming” is a new concept in auditing literature, and early in the adoption
process firms will need to decide how best to implement this requirement in practice. Keep in
mind that brainstorming is a required procedure and should be applied with the same degree of
due care as any other audit procedure. There are two primary objectives of the brainstorming

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session. The first is strategic in nature, so the engagement team will have a good understanding
of information that seasoned team members have about their experiences with the client and
how a fraud might be perpetrated and concealed. The second objective of the session is to set
the proper “tone at the top” for conducting the engagement.

PLANNING ANALYTICAL PROCEDURES:

One of the reasons auditors fail to detect material misstatements caused by fraud is that they
tend to look at current numbers in isolation from the past or other relevant information. For that
reason the auditor should consider the results of analytical procedures in identifying the risks of
material misstatement caused by fraud, and the standard provides a list of procedures auditors
can employ that may indicate the presence of such risks.

Improper revenue recognition

The vast majority of fraudulent financial reporting schemes involved improper revenue
recognition. Auditors should ordinarily presume there is risk of material misstatement due to
fraud relating to revenue recognition. If auditors do not identify improper revenue recognition
as a risk of material misstatement due to fraud, auditors should document the reasons supporting
this conclusion.

ADVERSE OR MODIFIED REPORT

Where an overall opinion cannot be expressed due to scope limitations, the Auditing Standard
requires auditor to explain why auditor cannot provide overall attestation opinion. First, auditors
must issue an adverse report on control when a material weakness is identified. More
importantly, the auditor’s report must describe the material weakness to provide the report’s
users “specific information about its nature” and “its actual or potential effect on the
presentation of the company’s financial statements.

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Second, auditors must issue modified reports when management’s assessment is inadequate. In
such cases, auditors must indicate a scope limitation on their report, indicating lack of adequate
review. In addition, auditors must issue modified reports when management’s report is
inappropriate. In these cases, auditors must include an explanatory paragraph describing the
reasons for this conclusion.