FERNANDEZ, HISHAM

BSAc 2B
EXTAUD 1

ENRON CORPORATION AND ANDERSEN, LLP Analyzing the Fall of Two Giants

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

-Enron faced the majority of the risks that any energy firm would experience,
including price volatility and foreign currency problems. The speculative nature of
Enron's business model, on the other hand, exposed the firm to numerous extra risks,
putting pressure on the company's management to adopt aggressive, and perhaps
fraudulent, financial reporting techniques. The firm was finally brought down by the
awareness of these threats. Enron acted as a broker of speculative energy (and other)
futures, which exposed the company to greatly magnified energy and other commodity
price risks. The company also offered financial hedges to its customers, exposing Enron
to risks such as interest rate and amplified foreign exchange risks. Enron was a major
player in hedging and contracting for supplies of electricity, an extremely competitive
business subject to price wars and environmental concerns. Enron conducted most of
its operations through the Internet, exposing the corporation to the risk of technology
failure. Finally, Enron operated in a variety of countries with varying regulatory and risk
profiles, including Europe and India.
As a number of Enron's business risks became apparent, the company's
management was put under intense pressure to generate positive financial results. For
at least two reasons, these demands were particularly intense at Enron. Firstly, many of
Enron's deals (including the SPEs referenced in the case) were largely reliant on a high
and rising stock price. This pressure existed because the corporation had guaranteed
its liabilities with stock and had contractually stipulated that if the stock price dropped
below specific levels, those debts would become instantly due and payable. Secondly,
the nature of Enron’s business required the confidence of its business partners in the
company’s ability to meet its future obligations to deliver electricity and other
commodities. If the company were to report poor or deteriorating financial results, its
partners might begin to question the company’s ability to meet its obligations and
consequently refuse to do business with the company. This is, in fact, what eventually
happened.

2. In your own words, summarize how Enron used SPEs to hide large amounts of
company debt.
 - The case mainly describes how Enron's SPEs were used to sell
underperforming assets, removing associated losses and liabilities from the company's
financial statements. As a result, students will need to conduct further study to have a
more thorough understanding of the many ways Enron exploited SPEs to conceal
business debt. In asking this question, the instructor should specify whether students
are required to merely summarize the facts provided in the case or to conduct further
outside research. SPEs are independent legal companies formed to achieve specific
corporate goals. Enron established SPEs to sell firm assets in order to report a cash
inflow and remove the assets and any associated liabilities from the balance sheet.
Such SPEs were legal as long as Enron secured an outside investment of at least three
percent of the value of the assets to be sold to the SPE. In other words, the outside
investors were to assume the risk of the investment. However, as an incentive to bear
the risk, Enron pledged company stock to the outside SPE investors to remove the risk
in the case that the assets were sold for a loss. These obligations were not understood
until Enron’s stock began to perform poorly, making the company unable to cover the
losses with shares of stock. “Chewco,” “LJM2,” and “Whitewing” were three of Enron’s
most prominent SPEs. Enron also allegedly hid debt by working with large investment
bankers to take on large loans that appeared like financial hedges rather than debt. The
Wall Street Journal summed up Enron’s use of SPEs to hide large amounts of company
debt with the following example: “The essence of the scam was simple: Let’s say you
had a clunker of a car but told your spouse you just sold it for twice what it was worth.
You neglect to mention, though, that you basically sold it to yourself because you lent
the buyer the money. Unless the car miraculously recovers its value, you’ll still eat a loss
when the buyer defaults and you’re forced to repossess. Enron’s shareholders were in
the position of the misled spouse. They saw the company shedding questionable or
volatile assets and getting paid well for them, but they weren’t told that Enron still bore
the risk in the form of various exotic loans to the nominally ‘independent’ buyers.”

3. What are the responsibilities of a company’s board of directors? [b] Could the
board of directors at Enron—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?

[a] The board of directors is in responsibility for ensuring that a company's

management is operating in the best interests of the company's owners. As a result, if
directors are remiss in their obligations, shareholders and others may hold them
accountable.
[b] Although we will never know if the board of directors could have avoided
Enron's demise, the board might have taken a number of initiatives to strengthen
corporate governance. According to a recent U.S. The Senate Permanent
Subcommittee of Investigation blamed the board of directors and the audit committee,
and suggested that boards adopt certain actions to strengthen corporate governance.
The following are the report's overarching recommendations: “Based upon the evidence
before it and the findings made in this report, the U.S. Senate Permanent Subcommittee
on Investigations makes the following recommendations: “(1) Strengthening Oversight.
Directors of publicly traded companies should take steps to: (a) prohibit accounting
practices and transactions that put the company at high risk of non-compliance with
generally accepted accounting principles and result in misleading and inaccurate
financial statements; (b) prohibit conflict of interest arrangements that allow company
transactions with a business owned or operated by senior company personnel; (c)
prohibit off-the-books activity used to make the company’s financial condition appear
better than it is, and require full public disclosure of all assets, liabilities and activities
that materially affect the company’s financial condition; (d) prevent excessive executive
compensation, including by (i) exercising ongoing oversight of compensation plans and
payments; (ii) barring the issuance of company-financed loans to directors and senior
officers of the company; and (iii) preventing stock-based compensation plans that
encourage company personnel to use improper accounting or other measures to
improperly increase the company stock price for personal gain; and (e) prohibit the
company’s outside auditor from also providing internal auditing or consulting services to
the company and from auditing its own work for the company. “(2) Strengthening
Independence. The Securities and Exchange Commission and the self-regulatory
organizations, including the national stock exchanges, should: (a) strengthen
requirements for Director independence at publicly traded companies, including by
requiring a majority of the outside Directors to be free of material financial ties to the
company other than through Director compensation; (b) strengthen requirements for
Audit Committees at publicly traded companies, including by requiring the Audit
Committee Chair to possess financial management or accounting expertise, and by
requiring a written Audit Committee charter that obligates the Committee to oversee the
company’s financial statements and accounting practices and to hire and fire the
outside auditor; and (c) strengthen requirements for auditor independence, including by
prohibiting the company’s outside auditor from simultaneously providing the company
with internal auditing or consulting services and from auditing its own work for the
company.”
Many of these motions for modification are now being evaluated as amendments
to NYSE and NASDAQ listing requirements. Congress effectively addressed some of
these concerns in the Sarbanes-Oxley Act.
[c] Many of these motions for modification are now being evaluated as
amendments to NYSE and NASDAQ listing requirements. Congress effectively
addressed some of these concerns in the Sarbanes-Oxley Act. The board of directors
appears to have realized the hazards and lack of independence with Enron's SPEs. If
the board had followed the guidelines given above, it could have discovered these
flaws. However, boards of directors have inherent limits that must be recognized. They
meet only on a periodic basis, without an independent investigative arm (and hence rely
on management and internal and external auditors for correct information), and do not
actively monitor the firms they serve on a full-time basis.

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

standards. How might fundamentally changing accounting standards from
bright-line rules to principles 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 “principles-based”
standards. Are there dangers in removing “bright-line” rules? What difficulties
might be associated with such a change?

-Rules-based accounting standards are specific and detailed, reading like the tax
or criminal law codes. A rules-based system of accounting standards attempts to create
a package of pre-fabricated decision models for every imaginable situation. Due to the
impossibility of defining every situation, individuals can sometimes justify a violation of
the spirit of the law by technically complying with the letter of the law. Principles-based
standards are general guidelines that describe how classes of transactions should be
reflected in general terms, requiring that the accounting appropriately reflect economic
substance. They allow accounting professionals to make judgments when determining
specific applications. A principles-based system of accounting standards would require
that accounting and auditing professionals possess the integrity and judgment
necessary to make appropriate decisions and would involve greater judgment and
discretion. Principles-based rules may prevent another Enron failure by requiring
accountants to make judgments regarding the “spirit of the law,” rather than just
regarding technical compliance with rules. In the case of Enron’s SPEs, for example,
Enron’s managers may have succeeded in pressuring auditors into accepting deceptive
financial reporting by pointing to the “bright-line” standard requiring a three percent
outside investment. Principles Based standards would require auditors to evaluate the
circumstances as a whole in order to determine whether the parent company in fact did
not have significant exposure in relation to the unconsolidated SPE. Removing
bright-line rules may also create problems in some circumstances because human
judgment and discretion are involved. Auditors and executives may rationalize
aggressive financial decisions and then defend themselves when questioned by
asserting that accounting standards do not specifically prohibit their actions.

5. 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 nonaudit services
for their audit clients. What do you believe?

External auditors must be independent toward the companies they audit. When
auditors start performing internal auditing and management consulting services for the
same companies they audit.
The Sarbanes-Oxley Act of 2002 was recently enacted by Congress in order to
strengthen the independence of public auditors. Section 201 of the Sarbanes-Oxley Act
expressly states that it is "unlawful" for a registered public accounting firm to perform
any non-audit service to an issuer contemporaneous with the audit, including: (1)
bookkeeping or other services related to the accounting records or financial statements
of the audit client; (2) financial information 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, investment adviser, or investment banking
services; (8) legal services and expert services unrelated to the audit; (9) any other
service that the Board determines, by regulation, is impermissible. The Board may, on a
case-by-case basis, exempt from these prohibitions any person, issuer, public
accounting firm, or transaction, subject to review by the Commission.
"It will not be illegal to supply additional non-audit services if they have been
pre-approved by the audit committee in the following manner. The bill authorizes an
accounting firm to 'engage in any non-audit service, including tax services,' that is not
listed above, only if the activity is pre-approved by the issuer's audit committee. The
audit committee's decision to pre-approve non-audit services will be disclosed to
investors in periodic reports. Statutory insurance company regulatory audits are treated
audit services and do not require prior approval. “The pre-approval requirement is
waived with respect to the provision of non-audit services for an issuer if the aggregate
amount of all such non-audit services provided to the issuer constitutes less than 5% of
the total amount of revenues paid by the issuer to its auditor (calculated on the basis of
revenues paid by the issuer during the fiscal year when the nonaudit services are
performed), such services were not recognized by the issuer at the time of the
engagement to be non-audit services; and such services are promptly brought to the
attention of the audit committee and approved prior to completion of the audit.
The authority to pre-approve services can be delegated to 1 or more members of
the audit committee, but any decision by the delegate must be presented to the full audit
committee.” Arguments for allowing auditors to perform external audit and other
services at the same time include:
• Auditors realize efficiencies by completing both external audit and internal audit
services. They reduce the number of hours required to complete both audits by
eliminating overlapping work.
• Auditors discover inefficiencies and other weaknesses while performing audit work.
They use their expertise and knowledge in providing consulting services to
management to improve these weaknesses.
• Auditors already have a relationship established with management. By providing other
services, they save the company time and money that would be spent in obtaining the
services of another organization unfamiliar with company policies and procedures.
• Auditors can act independently in the external audit when they are performing other
services.
• Legislation should not impede the freedom to pursue growth and revenues in different
lines of business in a free enterprise system. Arguments for not allowing auditors to
perform external audit and other services at the same time include:
• Auditors may not act independently in the external audit when they perform other
services. The incentives to perform consulting and/or audit services may lead to
impaired judgment.
• Internal audit services are best performed by in-house personnel who understand the
company’s culture and practices. Internal auditors are an important part of corporate
governance and should not be replaced by external auditors acting as internal auditors.
• The company benefits from multiple viewpoints. This includes viewpoints from
consultants and internal auditors who do not also serve as the company’s external
auditors.

6. Enron and Andersen suffered severe consequences because of their perceived

lack of integrity and damaged reputations. In fact, some people believe the fall of
Enron occurred because of a 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?

The run-on-the-bank analogy is applicable and valid to both firms, at least to

some extent, since such runs are triggered by investor loss of confidence and credibility.
If customers had been willing to continue using Enron's services, the company may
have avoided bankruptcy. The firm revealed significant debts and other liabilities, but it
also had a big revenue stream of more than $100 billion each year. Customers were no
longer willing to do business with Enron when it lost its credibility. In Andersen's
situation, the firm would have likely survived if the Enron ramifications had been
contained to the auditing office. Andersen was a large, established, multinational firm
and the loss of one client Enron’s size would not likely have proven the end of the firm.
Unfortunately, clients all over the world lost confidence in the firm’s
credibility—ultimately a public accounting firm’s only significant asset. As a result, many
clients in nearly all of Andersen’s many offices subsequently fired the firm as part of an
intensifying downward spiral.

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

This is a broad issue, and students' answers will reflect a wide range of
perspectives. The diversity of viewpoints should allow for an engaging and innovative
in-class discussion. However, some major points that should be mentioned are as
follows.
Public accounting is a highly competitive, service-oriented industry. Public
accounting companies, like most other service providers, have a vested interest in
impressing their clients by delivering value and outstanding customer service. Partners
may feel pressured to avoid taking hard stands on a client's accounting decisions in
order to give exceptional client service. Otherwise, partners risk losing customers to
competing accounting firms.
Moreover, public accounting companies are in the money-making industry.
Partners at a public accounting company are naturally interested in the firm's financial
success since, among other things, partner pay and incentives are based on yearly
sales. Partners are frequently held accountable for annual sales objectives and strive to
exceed them. One important point to mention is that audit fee income from firms like
Enron are extremely lucrative—audit Andersen's fee at Enron was around $48 million
per year.
Lastly, some claim that the provision of consulting, internal auditing, and other
services to auditing clients may have jeopardized auditors' capacity to be objective and
take firm tough stands on questionable accounting practices.Along these lines, it is
interesting to note that in 2000 Andersen earned more from Enron in consulting fees
than in auditing fees, with consulting fees topping $50 million in that year alone.
To overcome these challenges, auditors must be dedicated to putting the public
interest first. They must be open with each client, stating that while the accounting firm
desires to add value to the client's business, difficult judgments that contradict
management's view on some matters may have to be taken to safeguard the investing
public's interests. By establishing this groundwork, difficult decisions will be simpler to
make when they happen. Firms may need to reevaluate their performance evaluation
and compensation practices to determine whether they are incentivizing local partners
to embrace aggressive positions that are not in the best interests of the firm as a whole.
In addition, most large accounting firms require national approval for local office
partners to sign off on certain complex or aggressive accounting positions, mitigating
the sometimes strong individual pressures on local partners to please the client. Finally,
the Sarbanes-Oxley Act of 2002 now makes it illegal for external auditors to perform
internal auditing and a variety of management consulting services for the same
company.

8. 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?

This question is intended to encourage students to think imaginatively about

topics that do not have an unique correct answer. The following are some of the
concerns that students may have. In 2002, Congress approved the Sarbanes-Oxley Act,
which made it unlawful for auditors to undertake both external auditing and internal
auditing or management consulting at the same time. This bill also included additional
provisions aimed at restoring trust in the country's capital markets. For instance, the bill
required the creation of the Public Company Accounting Oversight Board (the PCAOB),
which is overseen by the SEC, thereby terminating the profession's long-standing
history of self-regulation.The board has authority over accounting firms that audit SEC
customers in the United States. It is evident that these efforts will not be enough to
restore confidence in the capital markets, because auditors and auditing were only part
of the problem that led to Enron and other early-2000s disasters. The NYSE and
NASDAQ have implemented a number of listing adjustments to increase board of
director governance over senior management. Finally, everyone involved in the system
must act responsibly. Auditors must prioritize the public interest. Companies must
demonstrate their commitment to correctly disclosing financial and operating information
on a regular basis, and a continuous process must be developed to improve and
maintain the quality of information presented to investors and creditors.