Professional Documents
Culture Documents
Comprehensive Case A.1 - Enron
Comprehensive Case A.1 - Enron
1 - Enron
To maximize the knowledge acquired by students, this book has been designed to be read in
conjunction with the post-Sarbanes-Oxleytechnical audit guidance. All of the PCAOB Auditing
Standards that are referenced in this book are available for free at:
http://www.pcaobus.org/Standards/index.aspx.
In addition, the AU Sections that are referenced in this book are available for free at:
http://www.pcaobus.org/Standards/Interim Standards/Auditing Standards/index.aspx. Finally, a
sununary of the provisions of the Sarbanes-Oxley Act of 2002 is available for free at:
http://thecaq.aicpa.org/Resources/Sarbanes+Oxley/Summary+of+the+Provisions+of +the+Sarba
n es-Oxley+Act+of+2002.htm.
1. What is auditor independence, and what is its significance to the audit profession? What is the difference
The second general standard of generally accepted auditing standards (GAAS) is, "In
by the auditor or auditors." If the auditor is not independent, the financial statements are
considered unaudited for all practical purposes. In case where the SEC has found that a CPA
firm was not independent, it has required that the financial statements be re-audited by another
organizations and litigation by those who relied on the financial statements (e.g., clients and
investors). The profession, as a whole, depends on the value of independence in that the
auditor's opinion on the financial statements loses its value if the auditor is not considered to
public practice should be independent in fact and appearance when providing auditing and other
Attestation services." To be independent in fact, an auditor must have integrity, a character of
intellectual honesty and candor; and objectivity, a state of mind of judicial impaiiiality that
auditor must not have any obligations or interests (in the client, its management, or its owners)
that could cause others to believe the auditor is biased with respect to the client, its management,
or its owners. Even if the auditor does not have any direct or indirect financial interest or
obligation with the client in fact, they must assure that no part of their behavior or actions appear
to affect their independence in the opinion of the public. When behavior seems to affect
The facts of the case reveal numerous issues that suggest that Andersen's independence
may have been compromised. For example, Emon was one of Andersen's biggest audit clients.
It paid Arthur Andersen $46.8 million in fees for auditing, business consulting, and tax work for
the fiscal year ended August 31, 1999; $58 million in 2000; and more than $50 million in 2001.
At Andersen, the compensation of partners depended on their ability to cross-sell other services
to its audit clients. More than half of the fees for Enron were charged for non-audit services. By
2001, Duncan was earning more than $1 million a year. The size of the fees would likely have
made it hard for Duncan and his fellow auditors to challenge Emon's management team on
incentivesto work as an advocate on behalf of Enron. For example, Arthur Andersen boasted
about the closeness of their relationship in a promotional video. " We basically do the same types
of things...We' re flying to kinda cross lines and trying to, you know, become more of just a
In addition, Since 1993 Andersen had perfonned Emon's internal audit function in
addition to performing the audit on its financial statements. Performing both the internal and
external auditing functions meant that Andersen was auditing its own work and thus would not
be unbiased. In addition, more than eighty former Arthur Andersen accountants were working at
Enron. Several were in senior executive positions, including Jeffrey McMahon, who served in
the positions of treasurer and president; and vice president Sherron Watkins; and chief
Article IV of the AICPA Code of Conduct (Objectivity and Independence) states: " A
member in public practice should be independent in fact and appearance when providing
auditing and other attestation se1vices." Close relationships might affect independence in
appearance, even if independence in fact is maintained. Clearly there was cause for concern at
Emon. Causey was good friends with Andersen's global engagement partner, David Duncan. In
fact, their fam ilies had even gone on vacations together. Andersen employees often attended
Enron-sponsored events and office parties. The nature of Causey and Duncan's close
appearance.
2. Refer to Section 201 of SARBOX. Identify the services provided by Arthur Andersen that are no
longer allowed to be performed. Do you believe that Section 201 is needed? Why or why not?
Section 201 says that it shall be unlawful for a registered public accounting firm to provide
any non-audit service to an issuer contemporaneously with the audit, including: (1) bookkeeping
or other services related to the accounting records or financial statements of the audit client; (2)
financial infonnation systems design and implementation; (3) appraisal or valuation services,
fairness opinions, or contribution-in-kind reports; (4) actuarial services; (5) internal audit
outsourcing services; (6) management functions or human resources; (7) broker or dealer,
investmentadviser, or investment banking services; (8) legal services and expert services
umelated to the audit; (9) any other service that the Board determines, by regulation, is
impennissible.
Arthur Andersen provided services to Enron that would be prohibited today by SOX
Section 201. "More than half of that amount (more than $50 million) was for fees that were
charged for nonaudit services ... $27 million for consulting and other se1vices, such as internal
audit se1vices." Andersen had been providing internal audit se1vices to Emon for eight years.
The nonaudit services that Andersen provided were encouraged by the structure of partner
compensation.
Importantly, the bill allows an accotmting fom to "engage in any non-audit service,
including tax services," that is not listed above, only if the activity is pre-approved by the audit
committee of the issuer. The audit committee is required to disclose to investorsin its periodic
Most observers now agree that Section 201 was needed. The rise of non-audit se1vices
has been a conunon trend in the public accounting profession. In 1993, 31% of the fees in the
industry came from consulting. By 1999, that number had jumped to 51%. In fact, the AICPA
released a publication in 1999 titled " Make Audits Pay: Leveraging the Audit Into Consulting
Se1vices." The book advised the auditor to think of himself as a " businessadvisor." It did note
that conflicts could arise from perfom1ing the role of business advisor (which was a client
advocate) and the auditor (which had to be independent). It advised erring on the side of looking
out for the public interest. Other striking examples include KPMG, which billed Motorola $3.9
million for auditing and $62.3 million for other services; Ernst & Young, which billed Sprint
Corp. $2.5 million for auditing and $63.8 million for other services; and
PricewaterhouseCoopers, which billed AT&T $7.9 million for auditing and $48.4 million for
other services.
3. Refer to Sections 203 and 206 of SARBOX. How would these sections of the law have impacted the
Enron audit? Do you believe that these sections rewere needed? Why or why not?
Section 203 says that the lead audit or coordinating partner and the reviewing partner must
rotate off of the audit every 5 years. Section 206 says that the CEO, Controller, CFO, Chief
Accounting Officer or person in an equivalent position cannot have been employed by the
company's audit fom during the 1-year period ("the cooling off period) proceeding the audit.
Section 203 could have impacted the Enron audit. Lead partner for the Enron engagement, David
Duncan had fonned a close personal relationship with Emon's Chief Accounting Officer,
Richard Causey. " ... and their families had even gone on vacations together." The nature of this
close relationship put Duncan in a position that he might not be able to challenge management. A
key point to raise in this response is that David Duncan would not have been the lead audit
partner after 5 years of service because of the establishment of Section 203. It is important to
point out that the relationship that develops among professionals is intenupted by regulation to
Section 206 requires a "one year cooling off period" for former Andersen employees to
accept a position as CEO, CFO, Controller, or Chief Accounting Officer. "Causey was
responsible for recruiting many Andersen alumni to work at Enron. Over the years, Emon hired
at least 86 Andersen accountants. Several were in senior executive positions." Section 206 of
SOX would have prevented some of these hirings before the cooling off period had expired.
Since both of these laws help to insure independence in appearance and in fact, most
students are likely to agree that they were needed. Both Section 203 and Section 206 would have
4. Refer to Section 301 of SARBOX. Do you believe that S ection 301 is important to maintaining
independence between the audito1· and the client? Why or why not?
Section 301 of SARBOX requires that the "audit committee of an issuer shall be directly
responsible for the appointment, compensation, and oversight of the work of any registered
public accounting fom employed by that issuer." As a result, the relationship between the audit
fim1 and the CFO and/or Controller at an audit client has changed dramatically. In the past, it
may have been difficult for an auditor to challenge the CFO and/or the Controller on difficult
accounting issues because the auditor knew that these individuals had the authority to fire the
audit firm from the job. At a minimum, this was a major tlu·eat to independence in appearance.
Now, the auditor reports directly to the audit committee. As a result, the independence between
5. Consider the principles, assumptions, and constraints of Generally Accepted Accounting Principles
(GAAP). Define the revenue recognition principle and explain why it is important to users of financial
statements.
The revenue recognition principle of GAAP states tl1at revenue must be both earned and
realized before it is recognized and is supported by the FASB Statement of Financial Concepts
No. 5. In addition, the amount of the sale needs to be fixed and detem1inable. Also, the
recognition of revenue is dependent on an assumption that the cash will be collected from the
customer in a timely manner. Other points that should be made to students are that the buyer
needs to assume the risks and rewards of ownership of the product (i.e., the risk of damage
or physical loss). In addition, for certain types of sales, the SEC has established specific and
In the case of Enron, the manner in which MTM accounting was applied to its trading
business was suspect. That is, by recognizing the present value of the stream of future
inflows under the entire contract as revenues and recognizing the present value of future
costs under the entire contract as expenses. Of course, this violated the revenue recognition
principle because Emon hadn't performed tmder the contract at the time it recognized
revenues.
6. Consider the Sithe Energies contract described in the case. Does the accounting for this contract provide
an example of how Enron violated the revenue recognition principle? Why or why not? Please be
specific.
According to GAAP, in order for revenue to be recognized, it must have been earned by the
company. In the present contex,t Enron used MTM accounting to allow for the recognition of
the present value of the stream of future inflows as revenues on its contract with Sithe Energies.
However, the application of MTM (in this context) clearly violates the revenue recognition
requirements under GAAP. Consider that Enron recognized revenue from the Sithe contract
before the Sithe plant had even begun its own operations. As a result, Enron had not done its
part in fulfilling its contract obligations. Thus, revenue on this contract was not yet earned and
the case information, do you believe that Enron had established an effective system of internal control
over financial reporting related to the contract revenue recorded in its financial statements? Why or why
not?
reporting provides reasonable assurance regarding the reliability of financial reporting and the
preparation of financial statement for external purposes. If one or more material weaknesses
exist, the company's internal control over financial repo1ting cannot be considered effective." In
the Appendix of Auditing Standard #5, paragraph #AS provides more specifics about the
According to that paragraph, such a system is "a process designed by, or under the
supervision of, the company's principal executive and principal financial officers, or persons
perforn1ing similar functions, and effected by the company's board of directors, management,
and other personnel, to provide reasonable assurance regarding the reliability of financial
reporting and the preparation of financial statements for external purposes in accordance with
GAAP and includes those policies and procedures that - (1) Pertain to the maintenance of
records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of
the assets of the company; (2) Provide reasonable assurance that transactions are recorded as
accounting principles, and that receipts and expenditures of the company are being made only in
accordance with authorizations of management and directors of the company; and (3) Provide
or disposition of the company's assets that could have a material effect on the financial
statements."
Enron did not have an effective system of internal control over financial reporting related to
contract revenue recorded in its financial statements. Stated simply, Emon's internal control
system does not provide reasonable assurance that revenue was being recorded fairly, and in
accordance with GAAP. Consider the valuation assertion. An example of a control procedure
that would help to prevent a material misstatement related to the valuation assertion related to
revenue would be to require an independent valuation finn to be responsible for valuing all
material contracts. When considering the discretion of an independent 3rd party upon an
estimate, the estimate can be considered more reliable and competent. Although this valuation
procedure can be costly to the client, the reliability of the estimate is far more valuable to users
that are dependent upon an unbiased and objective MTM estimate. An example of a control
procedure designed to detect a material misstatement related to the valuation assertion about
revenue would be to have the internal audit department perforn1 independent recalculations of
the valuation of material contracts. In such a situation, the internal audit department would be
responsible for evaluating (independent of management) the subjective components of the MTM
valuation to determine if the valuation is reasonable, reliable, and has competent evidence to
support the valuation. For example, an interest rate used in the calculation of an MTM valuation
must be supported by market infonnation that supports the use of a particular interest rate.
8. Consult Paragraphs .21-.22 of AU Section 326. As an auditor, what type of evidence would you want
to examine to determine whether Enron was inappropriately recording revenue from the Sithe
Energies contract?
its forn1, must be both valid and relevant." Indeed, "the validity of evidential matter is so
dependent on the circumstances under which it 1s obtained that generalizations about the
reliability of various kinds of evidence are subject to impo1iant exceptions ." So, the
competence of audit evidence refers to the quality of the evidence gathered for a financial
transaction(s). And, as indicated in the standard, there are two aspects to evidence quality that
are most important: relevance and reliability. The relevance of audit evidence specifically relates
to whether the evidence gathered actually relates to the financial statement asse1i ion being
tested. That is, will the evidence allow the auditor to reach conclusions related to that financial
statement assertion?
The reliability of the evidence specifically relates to whether the evidence gathered can trnly
be relied upon as providing a true indication about the financial statement assertion being tested.
There are a number of factors that should influence an auditor's conclusions about reliability, the
most important of which is the source (e.g., is it from a third party?) of the audit evidence.
According to paragraph #22 of AU Section 326, "The amount and kinds of evidential matter
required to support an infom1ed opinion are matters for the auditor to detennine in the exercise
of his or her professional judgment after a careful study of the circumstances in the particular
case." So, the sufficiency of audit evidence refers directly to the quantity of the audit evidence
gathered about a financial statement asse1i ion. All things being equal, the greater the risk of
material misstatement related to the financial statement assertion, the more audit evidence will
Recall that Enron employed MTM accounting on an agreement that Enron reached to supply
Sithe Energies with 195 million cubic feet of gas per day for 20 years for a plant that Sithe was
going to build in New York. The estimated value of the gas to be supplied was $3.5 to $4 billion.
At the moment the contract was signed, the present value of the stream of future inflows under
the contract was recognized as revenues and the present value of the expected costs of fulfilling
the contract were expensed. In order to determine whether Emon was properly accounting for
the contract, the auditor would need to gather competent and sufficient evidence related to the
contract.
In testing the contract, the auditor would have to gather sufficient and competent evidence to
ascertain how much work was completed under the contract. According to GAAP, revenue must
be earned and realized in order to be recorded. The bottom line is that inquiry of management,
recognition practices. While interviews of management may be an appropriate first step in the
evidence gathering process, the interviews cannot serve as the basis for an auditor's conclusion.
Students must always remember that the auditor must consider the source of the evidence when
evaluating the competence of evidence. And, given the elevated inherent risk for this
transaction, the competence of evidential matter relied upon would be even more important.
Stated simply, the auditor would have to examine documentary evidence that convinced the
9. Explain why an accounting and auditing research function (like Andersen's PSG) is important in the
operations of a CPA firm. What role does the function play in completing the audit?
In order to mitigate their risk of an audit failure, CPA firms must implement their own
system of internal controls to ensure that professional standards (and their own standards) of
audit quality are being met. Stated simply, a fim1 must have assurance that the work being
The accounting and auditing research ftmction (like Andersen's PSG) is an instrumental part
of a finn 's quality assurance process. Typically, the group is comprised of a CPA firm's leading
techn ical experts on accounting, auditing and industry-specific professional standards. Thus, if
an engagement paitner (like Andersen' s David Duncan) encounters a difficult technical issue,
he/she has the necessary technical support that may be necessary to reach the con-ect conclusion
in the field.
10. Consult Section 103 of SARBOX. Do you believe that the engagement leader of an audit (like David
Duncan on the Enron audit) should have the authority to overrule the opinions and recommendations of
the accounting and auditing research function (like the PSG)? Why or why not?
According to Section I03 of SOX, the "PCAOB shall: I) register public accounting fom s; 2)
establish, or adopt, by mle, " auditing, quality control, ethics, independence, and other standards
relating to the preparation of audit reports for issuers; 3) conduct inspections of accounting firms;
perfom1 such other duties or functions as necessary or appropriate; 6) enforce compliance with
the Act, the rules of the Board, professional standards, and the securities laws relating to the
preparation and issuance of audit reports and the obligations and liabilities of accountants with
respect thereto; 7) set the budget and manage the operations of the Board and the staff of the
Board."
In essence, this section of SOX provides for government regulation of the audit profession
and it represents one of most dramatic changes mandated by the new law. Indeed, this section
requires the PCAOB to perform detailed inspections of the audit process employed by each audit
fim1. In addition, PCAOB inspectors have the authority to review the audit work completed at
any publicly traded corporations. Considering that the audit profession has relied solely on peer
be allowed to ovenu le the firm's technical experts on an accounting or auditing matter. The
role of the technical experts is to provide information needed to make a correct decision on
a technical or complex matter. By the ve1y nature of the expert's role, they are used at a
time when the auditing professionals do not have the knowledge to make a correct decision.
To ovenule the expert would defeat the objective of the technical experts entirely.
In addition, in the post-Sarbanes environment, it is not likely that the PCAOB would agree
that the engagement paiiner on a particular audit should have the authority to ovenule the firm's
auditing and accounting research group. The bottom line is that since the function is in place to
insure a quality audit, it is likely that a PCAOB inspector would note this as an egregious
violation of a fim1 quality control procedure and may even issue some type of sanction against
the finn.
11. After Carl Bass was removed from the Enron account, he indicated to his boss that he did not believe
Enron should have known about internal discussions regarding accounting and auditing issues. Do
In general, it is hard not to agree with Carl Bass's position that Emon should not have known
about the internal discussions regarding accounting and auditing treatments. There are a number
of different points that can be made to support this view. They include:
• The firm has an obligation to maintain independence and objectivity per the
requirements of Rule 102 of the AICPA Code of Conduct. In order to maintain
independence and objectivity, the firm should have a policy that prevents this type of
communication with the client about the treatment of complex accounting or auditing
transactions. Collaboration with the client on these types of issues is comparable to
asking " their opinion", which of course would be a violation of independence
standards.
• It is absolutely not acceptable to allow the client to know about any internal
discussions related to a complex accounting and/or auditing issue. The firm's
position needs to be unified to the client in all cases. If employees of Enron knew
about such conversations, they may be able to understand the " thinking" behind
certain audit procedures and perhaps take actions to circumvent other audit
procedures that might be considered by the audit firn1. Additionally, sharing this
internal information violates independence in appearance.
12. Consult Section 203 of SARBOX. Do you believe that this provision of the law goes far enough? That is,
do you believe the audit firm itself (and not just the partner) should have to rotate off an audit
According to Section 203, the lead audit or coordinating partner and the reviewing partner
must rotate off of the audit every 5 years. Again, it is hard not to agree that some type of auditor
rotation should be required. However, there may be differences in opinion on whether this
provision goes far enough. Some thoughts raised by students may include:
• The current provision is not enough. Instead, Section 203 of SOX should require that the
audit firn1 should rotate off the engagement every five years. The fact is that the longer a
finn is involved with a client, the greater the chance that the film's objectivity will
become compromised as evidenced by the relationship between Andersen and Enron.
13. Consult Paragraph 9 of PCAOB AuditingStandard No. 5. Based on your understanding of inherent
risk assessment and the case information, identify three specific factors about Enron's business model
in the late 1990s that might cause you to elevate inherent risk at Enron.
At the entity and at the financial statement assertion level, inherent risk refers to the exposure
business model, including their products and se1vices is an essential part of an auditor' s inherent
risk assessment process at both the entity level and the financial statement assertion level.
Inherent risk assessment guides the auditor to allocating resources towards testing specific
accounts as well as what planning what substantive tests will be employed during testing.
Paragraph#9 of PCAOB Auditing Standard No. 5 relates to the planning of the audit of
internal control over financial reporting. Specifically, the paragraph says that such audit should
be properly planned and assistants, if any, are to be properly supervised. The paragraph then
goes on to explicitly identify matters that will impact the auditor's procedures. Several of the
relevant factors include: 1) Matters affecting the industry in which the company operates, such as
financial reporting practices, economic conditions, laws and regulations, and technological
changes; 2) Matters relating to the company's business, including its organization, operating
characteristics, and capital strncture; 3) Legal or regulatory matters of which the company is
Importantly, the factors that are likely to impact the audit of internal control over financial
reporting mirror the factors that are likely to impact the assessment of inherent risk in a financial
statement audit. This is a key learning point for this question. In the 1980s, while employing an
asset heavy strategy, Enron was a relatively simple enterprise, with a straight forward business
model. As such, the inherent risk assessment is likely to have been much lower in the 1980s than
in the late 1990s. In the late 1990s, there were a number of factors that would result in a higher
• Since Enron was now contracting with other pipeline companies to get their gas to
certain customer (e.g., Brooklyn Union), Enron was assuming added risks related to
the transpo1iation of the gas. Enron' s assumption of additional operational risk
increases the overall inherent risk level for Enron.
• Enron entered into many long tern1 contracts with their clients. Because the tenns of
the contract (e.g. price) was purely speculative, Enron was assuming additional risk
that the future price of their products (e.g. gas) would rise above the contract price.
The nature of many of their long-tern1 contracts was now riskier because prices
could rise to a level that would make the contract unprofitable.
• Enron became regularly involved with the trading and financing of nah1ral gas
contracts. The accounting for such contracts is complex. In addition, the natural gas
contracts it devised were quite complex and variable, depending on different pricing,
capacity, and transportation parameters. Complex business transactions require
complex accounting. As a result, inherent risk increases for complex transactions
because it requires the independent auditor to possess complex technical knowledge
regarding the appropriate accounting for the transaction.
• Enron decided to apply its "trading model" to other commodity markets, including
electricity, paper and chemicals. Due to the fact that these conunodity markets were
a new focus for Emon, there is risk associated with the possibility that the "trading
models" would not be fundamentally appropriate for the other commodity markets.
• Enron began using mark to market (MTM) accounting for its trading business. Enron
was the first company outside the financial services industry to use MTM accounting.
MTM accounting involves a series of subjective valuations that require management
discretion.
• Emon also began establishing several "special purpose entities," which were formed
to accomplish specific tasks, such as building gas pipelines. An SPE could be utilized
by a company hoping to achieve certain accounting purposes, such as hiding debt or
certain assets.
14. Consult Paragraphs .03-.06 of AU Section 311. Comment on how your understanding of the inherent
risks identified at Enron (in Question 13) would influence the nature, timing, and extent of your audit
work at Enron.
According to paragraph #5 of AU Section 311 " In planning the audit, the auditor should
consider the nature, extent, and timing of work to be perfom1ed and should prepare a written
audit program (or set of written audit programs) for every audit. The audit program should set
forth in reasonable detail the audit procedures that the auditor believes are necessary to
accomplish the objectives of the audit. The fonn of the audit program and the extent of its detail
will vary with the circumstances. In developing the program, the auditor should be guided by the
results of the planning considerations and procedures. As the audit progresses, changed
conditions may make it necessary to modify planned audit procedures." As a general rule, the
lower the risk of material misstatement, the less audit attention is needed during the audit. It
therefore follows that the higher the risk of material misstatement; the more audit attention is
needed during the audit. Although this is somewhat obvious, it is a basic point that needs to be
Clearly the nature, timing and extent of audit work should change as a result of the auditor's
risk assessment. Specifically, "if the risk is lower, the persuasiveness of the evidence that the
auditor needs to obtain also decreases." On the other hand, as the risk increases, the
persuasiveness of the evidence that the auditor needs to obtain also increases. Regarding the
timing of testing for controls, "as the risk associated with the control being tested decreases, the
testing may be perfom1ed farther from the as-of date; on the other hand, as the risk associated
with the control increases, the testing should be performed closer to the as-of date." Finally,
regarding extent of testing for controls, "as the risk associated with a control decreases, the
extensiveness of the auditor's testing should decrease; as the risk associated with a control
In addition, Paragraph#46 of PCAOB Auditing Standard No. 5 also provides some relevant
guidance for this question. Specifically, the paragraph states that "the evidence necessary to
persuade the auditor that the control is effective depends upon the risk associated with the
control." Specifically, if the risk is lower, the evidence needed to persuade the auditor about its
effectiveness decreases. On the other hand, as the risk increases, the evidence needed to
15. Consult Paragraphs 28- 30 of PCAOB Auditing Standard No. 5. Next, consider how the change in
industry regulation and Enron's resulting strategy shift would impact your inherent risk assessment
for the relevant assertions about revenue. Finally, idenity the most relevant assertion for revenue
before and after Enron's resulting strategy shift and briefly explain why.
Among other matters, paragraphs #28-30 of PCAOB Auditing Standard No. 5 focuses the
auditor's attention on the impo1tance of identifying each of the relevant financial statement
asse1tions related to significant accounts and disclosures. Indeed, the identification of relevant
assertions is a critical component of the audit of internal control over financial reporting.
Specifically, according to Paragraph # 28, "relevant assertions are those financial statement
assertions that have a reasonable possibility of containing a misstatement that would cause the
the likely sources of potential misstatements by asking himself or herself " what could go
wrong?" within a given significant account or disclosure." It is clear that certain financial
statement asse1tions are "more" relevant than others for a paiticular set of financial statements.
When Emon shifted from the "asset heavy" strategy to the "asset light" strategy, Emon
essentially was operating in a "new" industry because it faced an entirely new business
environment, with new industry regulations. As a result, the likelihood that a material
misstatement could occur has increased due to the possibility of Enron (or Andersen) not fully
understanding all aspects of the new regulated industry environment and the relevant accounting
guidance. This change in business environment and a necessary understanding of the related
aspects of a new industry represents an increase in inherent risk that material misstatement could
occur.
For the Revenue account, among others, there are two relevant assertions that stand out.
Specifically, the resulting strategy change at Enron would significantlyincrease inherent risk
assessment related to the Valuation or Allocation assertion for revenue recognized on contracts
when using mark-to-market accounting. That is, given the number of estimates used when
determining the specific amount of revenue to be recognized, inherent risk would be elevated. In
addition, the inherent risk related to the Occurrence assertion would also be elevated since it is
not entirely clear whether the revenue related to such contracts should have been recognized
under GAAP. In addition, the Existence or Occurrence assertion related to revenue recognized
from international subsidiaries and/or SPEs would also be elevated. The implementationof
several international subsidiaries and/or SPEs increases the likelihood that revenue fraud
tlu·ough related party transactions could occur. As such, an elevation of the level of inherent risk
occurs.
16. Consult Paragraphs .14-.16 of AU Section 316. How might a revenue recognition fraud occur under
Enron's strategy in the late 1990s. Identify an internal control procedure that would prevent, detect,
According to paragraph #14 of AU Section 316, on each audit engagement " members of the
audit team should discuss the potential for material misstatement due to fraud." According to
paragraph #15 of AU Section 316, this discussion "should include a consideration of the known
external and internal factors affecting the entity that might (a) create incentives/pressures for
management and others to co1mnit fraud, (b) provide the opportunity for fraud to be
perpetrated, and (c) indicate a culture or environment that enables management to rationalize
committing fraud." Of course, these three factors are commonly refened to as the "fraud
company is likely to either have incentives in place (e.g., bonus compensation) or be under
significant pressure to achieve meet specific estimates, forecasts, or expectations. The second
condition (opportunity) recognizes that in order for a fraud to be perpetrated, the internal control
commit a fraudulent act. Finally, the third condition (rationalization) recognizes that for an
employee or a manager of a company to perpetrate a fraud, the individual (or individuals) must
possess an "attitude" that allows them to rationalize that they are knowingly committing a crime.
Clearly, there are a number of allowable answers to this question. The absolute key is that
students show that they have tried to " brainstorm" about how a fraud might occur at Enron. As
long as this has been demonstrated, we recommend that credit be awarded for this question.
Importantly, this question is also designed to help the students understand the
differences between preventive controls and detective controls and the importance of
each in a well-
functioning internal control system. The absolute key to answering this part of the question is to
students must be able to identify a control procedure that would prevent specific misstatements
For example, one control procedure that could be designed to prevent a fraud related to the
approve all relevant assumptions used to estimate the amount of revenue to record related to a
particular contract. In addition, another possible revenue fraud would involve side agreements
within related party transactions. As Enron began to implement international subsidiaries and/or
SPEs, there is an increased likelihood that not all revenue transactions were completed as an
activities such as documentation and appropriate approvals for all related party transactions.
17. Consult Paragraphs .07-.08 of AU Section 316. Based on your understanding of fraud risk assessment,
what three conditions are likely to be present when fraud occurs (the fraud triangle)? Based on the
information provided in the case, which of these three conditions appears to have been the most prevalent
when fraud occurs. First, management or other employees have an incentive or are under
press ure , which provides a reason to commit fraud. Second, circumstances exist- for
controls- that provide an opportunity for a fraud to be perpetrated. Third, those involved are
able to rationalize committing a fraudulent act. Some individuals possess an attit ude ,
character, or set
of ethical values that allow them to knowingly and intentionally commit a dishonest act.
However, even otherwise honest individuals can commit fraud in an environment that imposes
sufficient pressure on them. The greater the incentive or pressure, the more likely an individual
The tlu·ee conditions that are likely to be present comprise what is commonly referred to
as the "fraud triangle". The first condition (incentives/pressure) recognizes that an employee
or expectations. The second condition (opportunity) recognizes that in order for a fraud to be
perpetrated, the internal control environment must provide an opportunity for an employee
commit fraud, there must be a weakness in the operating effectiveness of a control or a non-
existent control. Finally, the third condition (rationalization) recognizes that for an
must possess an "attitude" that allows them to rationalize that they are knowingly
committing a crime.
For Enron, as evidenced by the case inforn1ation, the incentives and pressure was the most
prevalent factor. For example, executives had incentive to achieve high revenue growth because
their salary and bonus levels were directly linked to reported revenues. In addition, they also had
incentive to achieve high revenues and earnings targets because of the shares of stock they held.
That is, Enron made significant use of stock options as a means to provide incentives for its
executives to achieve growth. Indeed, as of December 31, 2000, Enron dedicated 96 million of
its outstanding shares (almost 13 percent of its common shares outstanding) to stock option
plans. When a senior manager holds a quantity of stock options, it is in their personal best
interest to see the value of the share go up even if it means overstating income fraudulently. This
18. Consult Paragraph 25 of PCAOB Auditing Standard No. 5. Define what is meant by control environment.
Why is the control environment so important to effective internal control over financial reporting at an
understand the control environment. Indeed, " becauseof its importance to effective internal
control over financial reporting, the auditor must evaluate the control environment at the
and is therefore often refened to as "the tone at the top". With respect to the control
environment, the absolute key for management is to try and impact the attitudes towards internal
controls throughout the organization by setting the proper example for the organization to
follow.
According to paragraph #25, "As part of evaluating the control enviromnent, the auditor
should assess -
• Whether management's philosophy and operating style promote effective internal control
• Whether sound integrity and ethical values, paiticularly of top management, are developed
The control enviromnent has a "pervasive" effect on the reliability of financial repo1ting at
Enron and all audit clients because it impacts ALL other components of an organization's
internal control system. The lack of an appropriate control environment sends a message to all
employees that management does not believe internal controls are important for efficiency and
While it is difficult to glean inforn1ation that would allow for a complete evaluation of the
integrity of Emon's management, their competence, their leadership style, or their perceived
honesty from the case materials, students should point out that Emon' s compensation philosophy
(as an example of the company's human resource process) should raise concern about their
control environment. " At Emon, executives had incentives to achieve high-revenue growth
because their salaiy increases and cash bonus amounts were linked to repo1ted revenue. " This
policy sends a message to employees that above all it is important to meet financial
expectations.
In fact, the Enron case provides a terrific context to illustrate that an organization's
"One Emon employee said, ' At the time, it was a great tool... When we started the ranking
process, we were trying to week out the lower 5 or 6 percent of the company."' This control
intends to strip Enron of employees who are not adding value to their business processes.
However, it does not appear that Enron has taken advantage of this opportunity. The nature of
the ranking system established a cutthroat control environment where everyone fought for
themselves and did whatever they could to meet or exceed the financial expectations placed upon
them. Overall, by the end of class discussion, it should be clear that a proper control
environment importance provides a platfonn or a foundation for the entire internal control
system.
19. Consult Paragraphs 21-22 of PCAOB Auditing Standard No. 5. Comment on how your understanding
of Enron's control environment and other entity-level controls would help you implement a top-down
According to paragraph #21 of PCAOB Auditing Standard No. 5, "The auditor should use a
top-down approach to the audit of internal control over financial reporting to select the controls
to test. A top-down approach begins at the financial statement level and with the auditor's
understanding of the overall risks to internal control over financial reporting. The auditor then
focuses on entity-level controls and works down to significant accounts and disclosures and their
relevant assertions. This approach directs the auditor's attention to accounts, disclosures, and
In paragraph #22, the PCAOB states that the "auditor must test those entity-level controls
that are important to the auditor's conclusion about whether the company has effective internal
control over financial reporting. The auditor's evaluation of entity-level controls can result in
increasingor decreasing the testing that the auditor otherwise would have performed on other
controls." The absolute goal of this process is to help the auditor focus on those controls that
While it is difficult to glean information that would allow for a complete evaluation of
Emon's control environment and entity level controls, the case does provide enough detail to
conclude that the integrity of Enron's management, their leadership style, and their compensation
philosophy should raise concern about their control environment and perhaps other entity level
controls. Overall, by the end of class discussion, it should be clear that a proper functioning
control environment and strong entity level controls provide a foundation for the entire internal
control system.
20. Consult Paragraph 69 of PCAOB Auditing Standard No. 5 and Sections 204 and 301 of SARBOX. What
is the role of the audit committee in the financial reporting process? Do you believe that an audit
It is important to note that paragraph #69 of Auditing Standard No. 5 explicitly notes that
"ineffective oversight of the company's external financial reporting and internal control over
internal control over financial reporting. This of course has elevated the importance of the audit
committee. In addition, the audit committee plays an important role as a liaison with a
company's auditor. According to Section 301 of SOX, the "audit committee of an issuer shall be
directly responsible for the appointment, compensation, and oversight of the work of any
registered public accounting firm employed by that issuer." Moreover, according to Section 204,
the auditing fom must report all "critical accounting policies and practices" and " all alternative
treatments of financial infonnation within [GAAP] that have been discussed with management"
as well as the " ramifications of the use of such alternative disclosures and treatments, and the
treatment prefen ed" by the auditing fom. This is an impo1tant component of the oversight role
For Enron, the audit committee can absolutely be effective in helping to insure fair and
accurate financial reporting. Specifically, the audit co1mnittee can help to insure that an
organization's tone at the top is properly established. In addition, an audit committee can
have important input into the compensation policies at an audit client. That is, the audit
co1mnittee can help insure that an organization is not providing extra incentives to
tied to the financial perfom1ance of the company, there is strong motivation to commit a
fraudulent act in order to "earn" a personal compensation incentive. Or, they can help to include
perfom1ance measures for fair and reliable financial reporting in the compensation structure for
21. Consult Sections 302 and 305 and Title IX of SARBOX. Do you believe that these new provisions
could help deter fraudulent financial reporting by an upper management group? Why or why not?
According to section 302 of SOX, in the post-Sarbanes audit environment, the CEO and CFO
of each issuer must now prepare a statement to accompany the audit report to certify the
"appropriateness of the financial statements and disclosures contained in the periodic report, and
that those financial statements and disclosures fairly present, in all material respects, the
operations and financial condition of the issuer." If a CEO or CFO violates this section, he/she
can be held criminally liable. Essentially this statement holds the CEO and the CFO personally
liable for the assertions that they have made within the financial statements. And, under Title IX
of SOX, the maximum penalty for filing false financial statements with the SEC "for willful and
knowing violations" are " a fine of not more than $5,000,000 and/or imprisonment ofup to 20
years." This is an absolutely critical point that must be made to answer this question. The
bottom line is that crime does not pay! Imprisonment and financial penalties have been
A further illustration of the point that crime really does not pay can be found in Section 305
of SOX. According to Section 305, if a company is ultimately required to restate their financial
statement with the SEC due to "material noncompliance" with financial reporting rule, the CEO
and CFO are now required to "reimburse the issuer for any bonus or other incentive-based or
equity-based compensation received during the twelve months following the issuance or filing of
the noncompliant document and any profits realized from the sale of securities of the issuer"
Given the changes brought upon by SOX, these new provisions are likely to deter fraudulent
behavior. Stated simply, the penalties are severe and if it is found that such an upper manager
did profit from a fraudulent act, the law now provides a clear mechanism to get the money
back; not only to repay the financial benefit but also to incur punitive penalties as well,
22. Consult the key provisions of Emerging Issues Task Force (EITF) 90-15. How did Enron's Chewco SPE
fail to meet the outside equity requirement for nonconsolidation? Did Enron meet the control
According to EITF 90-15, in order for Enron to not consolidate an SPE, there must be an
independentowner of the SPE with at least a 3% ownership interest, and that interest must
remain at risk throughout the transaction. Importantly, the independent owner must also
In the Chewco SPE situation, the "outside" owners that comprised the necessary 3%
ownership interest were not truly independent from Enron. Specifically, in substance,
Michael Kopper, an Enron employee who repo1ted to Andrew Fastow (Enron' s CFO), was
in control of the entity, even though the partnership agreement provided some limits on the
general part ner ' s ability to manage the partnership's affairs. As a result, Enron did not meet
the control requirement for non-consolidation because they did not have an independent
owner exercise control over the SPE. Instead, Enron put one of its own people, Michael
Kopper, who had been reporting to a top Enron manager, as manager of Chewco.
In addition, while the majority of the 3% interest came from an entity called Big River
Funding LLC (whose sole member was an entity called Little River Funding LLC), most of
this money was provided by Barclays Bank ($11.4 Million) in the fonn of "equity loans" to
Big River and Little River. And since Barclays Bank required Big River and Little River to
establish cash reserve accounts of $6.6 million that were fully pledged to secure repayment
of the $11.4 million, there was never really 3% at risk throughout the transaction. This
violates EITF 90-15 because the independent owner (who was not really independent) did
not maintain a 3% owner that was at risk throughout the transaction. As a result, Chewco
did not meet the independent ownership requirement for nonconsolidation, nor did Enron
23. Based on your understanding of the audit evidence, did Arthur Andersen rely on sufficient and
competent audit evidence in its audit of the Chewco transaction? Why or why not?
The competence of audit evidence refers to the quality of the evidence gathered for a
financial statement assertion about a financial statement account balance and/or an economic
transaction(s). There are two aspects to evidence quality that are most important: relevance
and reliability. The relevance of audit evidence specifically relates to whether the evidence
gathered actually relates to the financial statement assertion being tested. That is, will the
evidence allow the auditor to reach conclusions related to that particular financial statement
assertion?
The reliability of the evidence specifically relates to whether the evidence gathered can
trnly be relied upon as providing a tlue indication about the financial statement assertion
being tested. There are a number of factors that should influence an auditor' s conclusions
about reliability, the most important of which is probably the source (e.g., is it from an
The sufficiency of audit evidence refers directly to the quantity of the audit evidence
gathered about a financial statement assertion. All things being equal, the greater the risk of
material misstatement related to the financial statement assertion, the more audit evidence
will be gathered by the auditor. An auditor must obtain sufficient audit evidence that they are
able to gain comfort over the assertion with the financial statements.
On the Chewco transaction, Anderson did not obtain sufficient and competent audit
evidence when examining the Chewco transaction. For example, Andersen requested that
Emon provide documents relating to Chewco's fo1mation and strncture. Given Emon's
ownership of JEDI and its involvement with Chewco transaction, this was absolutely
essential. However, Emon told Andersen that it did not have these documents and could not
obtain them because Chewco was a third party with its own legal counsel and ownership
independent ofEmon. The fact is that Jedi's ownership in Chewco and Enron's ownership in
JEDI meant that Andersen needed to review this evidence. Thus, Enron's response that they
did not have these documents was inadequate and Andersen should have demanded to
examine this information. In fact, Andersen should have threatened to disclaim their opinion
In addition, the evidence that Andersen did rely on for the Chewco transaction was not
competent. While Andersen did receive a confinnation regarding the loan agreement from a
Chewco representative, the reliability of the body of evidence should have been questioned
• A representation letter from Emon and a representation letter from JEDI, each of
which stated that related party transactions had been disclosed and that all
financial records and related data had been made available to Andersen.
than internal documents. The auditor must consider the nature of the source from which the
evidence is derived.
24. Consult Section 401 of SARBOX. How would Section 401 apply on the Enron audit? Do you think
Section 401 would have improved the presentation of Enron's financial statements? Why or why not?
Section 401 of SOX explicitly requires that each set of financial statements (and related
disclosures) that is required to be prepared in accordance with GAAP, shall disclose all
entities" that may have a material cuITent or future effect on the financial condition of the
issuer." It is abundantly clear that the inclusion of this section of SOX was based on
restatement ofEmon's financial statements due to its SPE relationships,namely the Chewco
entity.
There is no doubt that Section 401 of SOX would have dramatically improved the
presentation of Emon's financial statements. Consider that when the Chewco transaction was
reviewed in October/November 2001, Enron and Andersen concluded that Chewco was an SPE
without sufficient outside equity and that it should have been consolidated into Emon's financial
statements. The retroactive consolidation of Chewco and the investment partnership in which
Chewco was a limited partner had a largely material impact on the financial statements of
Enron. The retroactive consolidation in the restatements decreased Emon 's repo1ted net income
by $28 million (out of $105 million total) in 1997, by $133 million (out of $703 million total) in
1998, by $153 million (out of $893 million total) in 1999, by and by $91 million (out of $979
million total) in 2000. The restatement also increased Emon 's repo1ted debt by $711 million in
1997, by
$561 million in 1998, by $685 million in 1999, and by $628 million in 2000.
25. Consult Paragraphs .03-.08 of AUSection 326. Identify at least one relevantfinancial statement
assertion about the financial statementaccounts related to the Chewco transaction. Provide
For the Chewco transaction, there are at least two relevant assertions that the auditor should
identify when auditing internal control over financial reporting. First, is the completeness
asse1tion related to Emon 's long term liabilities? Clearly, there were significant long term
liabilities that were "hidden" off the balance sheet and on the balance sheet of a non-consolidated
SPE. The Chewco entity should have been properly consolidated within the financial statements
of Enron, as a result the reported long tern1 liabilities were understated. Second is the
presentation and disclosure assertion related to disclosure of the Chewco special purpose entity?
There was not proper disclosure of the related party Chewco, as it did not meet the control
rules to electric power contracts, like the Eli Lilly contract. Assuming the employee knew that
the use of MTM accounting was beyond the scope of the SEC approval parameters, do you
believe that the employee had a responsibility to report the behavior to the audit committee?
Clearly, there are a number of allowable answers to this question. The absolute key is for a
student to try and justify his or her position. Consider the following acceptable sample answer
from a student:
Yes, I do believe that the employee had a responsibility to report the use of MTM accounting
beyond the scope of SEC approval to the audit committee. The employee should have realized
that while the short term benefits of taking this action may seem promising on the surface, the
long term effects will ultimately be harmful. In my opinion, such an employee should follow a
constant maxim. Their maxim in this example should have been not to apply the MTM
accounting rnles to any transaction that was beyond the scope of SEC approval. If it was applied
and they knew about the action, they should have reported the action to the audit committee.