Enron Corporation: A Case Study
Course Name: Corporate Financial Reporting
Course Code: AIS 3202
Submitted to
Abdul Alim Baser
Lecturer, Department of AIS
University of Barisal
Submitted by
Tusher Ghosh
On behalf of Group 05
12 AIS 058
6th Semester
Batch: 1st
Department of AIS
University of Barisal
Date of submission
13 March, 2016
1
List of Group Members:
S.N.
Name
Roll Number
01
 Sumona Sarmin
12 AIS 007
02
 Nowrin Akter
12 AIS 016
03
 Kamrun Nesa Moumita
12 AIS 017
04
 Aysha Arabi
12 AIS 028
05
 Nipa Akter
12 AIS 046
06
 Farjana Akter Papri
12 AIS 056
07
 Tusher Ghosh (GL)
12 AIS 058
08
 Md. Tanjil Biswas
12 AIS 066
Table: Member list of Group 05
2
Acknowledgement
Enron, a corporation headquartered in Houston, operated one of the largest natural gas
transmission networks in North America, totaling over 36,000 miles, in addition to being the
largest marketer of natural gas and electricity in the United States. Enron managed the
world's largest portfolio of natural gas risk management contracts and pioneered innovative
trading products. The company was on Fortune's "Most Innovative" in the United States
listing for several years running and reached #7 on the Fortune 500 list in 2000. Its
bankruptcy in December 2001 was the largest such filing in United States history. The name
Enron became synonymous with corporate greed and corruption, and its demise cost
investors and employees over $70 billion in lost capitalization and retirement benefits.
As a part of academic program, we have prepared this report on “Enron Corporation: A Case
Study”. Our endeavor will come true if the actual purpose of this study becomes fulfilled.
At the very first, we would like to express our cordial and deep respect to the course teacher,
Abdul Alim Baser, Lecturer, Department of AIS, for his proper guidance, valuable advice,
instructions which helped us a lot to complete this study. We are very lucky for getting this
opportunity to complete this report under his guidance and supervision.
We owe our deepest gratitude to our parents and family members. We would not be able to
complete the study successfully devoid of their continuous inspiration and encouragement.
Finally, all praise and indebtness to the Almighty God, the Lord of Glory and Honor, for all
the blessing showers upon us to complete such a study.
3
Letter of Transmittal
13 March, 2016
Abdul Alim Baser
Lecturer
Department of AIS,
University of Barisal,
Barisal.
Subject: Submission of Report on “Enron Corporation: A Case Study”.
Dear Sir,
This is the report which is suggested by you as a part of our academic program for the Course
of Corporate Financial Reporting, Course code: AIS 3202. This report has been prepared to
cover topic “Enron Corporation: A Case Study”. We have tried our level best to make it done
as per your instructions. Our level best trying has given here to carry out a meaningful and
effective study on this topic to make the study efficient enough.
We shall be always available for any supplementary interoperation & thank you for giving us
the opportunity to complete a report on the above topic. We do sincerely hope this report will
live up to your expectation.
Sincerely yours,
Tusher Ghosh
On behalf of Group 05
12 AIS 058
6th Semester
Batch: 1st
Department of AIS
University of Barisal
4
Declaration
I, on behalf of Group 05, do hereby solemnly declare that the work presented in this report
has been carried out by myself and has not been previously submitted to any other
University/College/Organization for an academic qualification / certificate/ diploma or
degree.
The work I have presented does not breach any existing copyright and no portion of this
report is copied from any work done earlier for a degree or otherwise.
I, on behalf of Group 05, further undertake to indemnify the Department against any loss or
damage arising from breach of the foregoing obligations.
Tusher Ghosh
On behalf of Group 05
12 AIS 058
6th Semester
Batch: 1st
Department of AIS
University of Barisal
5
Chapter 01: Overview of Enron Corporation
1.1 Preface
1.2 History of Enron Corporation
1.2.1 Birth of the Company
1.2.2 Public Offerings in 1940s
1.2.3 Growth through Acquisitions
1.2.4 Rename to Enron
1.2.5 Enron: Before Collapse
1.3 Enron’s Corporate Profile
1.3.1 Central Management of Enron Corporation
1.3.2 Products of Enron Corporation
1.3.3 Enron’s Financial Performance (1996-2000)
1.4 Conclusion
Chapter 02: The Enron Collapse
2.1 The Fall of Enron
2.2 Why Enron Fell from Grace
2.2.1 SPE
2.2.2 Accounting Issue
2.2.3 The Crash of Enron
2.2.4 Enron’s Auditor (Arthur Andersen)
2.2.5 Links with The Government (Bush Administration)
2.2.6 The Link of Enron with The British Front
2.3 The consequences of Enron Collapse
2.3.1 The Victim: Employees and Pension Fund Holders
2.3.2 Creation of Sarbanes-Oxley Act
2.4 Punishment
2.5 What then is the Solution?
2.6 Conclusion
Chapter: 03 Case Questions Solution
3.1 Questions 1-7 & Answers (Auditing Cases- Knapp 8th edition, Case 1.1 Enron
Corporation)
3.2 Conclusion
6
Chapter 01: Overview of Enron Corporation
1.1 Preface
Enron Corporation was an American energy, commodities, and services providing company
based in Houston, Texas. Before its bankruptcy on December 2, 2001, Enron employed
approximately 20,000 staff and was one of the
world's major electricity, natural gas,
communications, and pulp and paper
companies, with claimed revenues of nearly
$111 billion during 2000. Fortune, an American
business magazine, named Enron "America's
Most Innovative Company" for six consecutive
years. The story ends with the bankruptcy of
one of America's largest corporations. Enron's
collapse affected the lives of thousands of
employees, shareholders and other investors. At
the end of 2001, it was revealed that its reported
financial condition was sustained by an
institutionalized, systematic, and creatively
planned accounting fraud, known since as the Enron scandal. Enron has since become a wellknown example of willful corporate fraud and corruption. The scandal also brought into the
question of the accounting practices and activities of many corporations in the United States
and was a factor in the enactment of the Sarbanes–Oxley Act of 20021. The scandal also
affected the greater business world by causing the dissolution of the Arthur Andersen
accounting firm.
1.2 History of Enron Corporation
1.2.1 Birth of the Company
Enron began as Northern Natural Gas Company, organized in Omaha, Nebraska, in 1930 by
three other companies. North American Light & Power Company and United Light &
Railways Company each held a 35 percent stake in the new enterprise, while Lone Star Gas
Corporation owned the remaining 30 percent. The company's founding came just a few
months after the stock market crash of 19292, an inauspicious time to launch a new venture.
Several aspects of the Great Depression actually worked in Northern's favor, however.
Consumers initially were not enthusiastic about natural gas as a heating fuel, but its low cost
led to its acceptance during tough economic times. High unemployment brought the new
company a ready supply of cheap labor to build its pipeline system. In addition, the 24-inch
steel pipe, which could transport six times the amount of gas carried by 12-inch cast iron
pipe, had just been developed. Northern grew rapidly in the 1930s, doubling its system
1
The Sarbanes-Oxley Act of 2002 (often shortened to SOX) is legislation passed by the U.S. Congress to
protect shareholders and the general public from accounting errors and fraudulent practices in the enterprise, as
well as improve the accuracy of corporate disclosures. The U.S. Securities and Exchange Commission (SEC)
administers the act, which sets deadlines for compliance and publishes rules on requirements.
2
The Wall Street Crash of 1929, also known as Black Tuesday (October 29) that began on October 24, 1929
and was the most devastating stock market crash in the history of the United States.
7
capacity within two years of its incorporation and bringing the first natural gas supply to the
state of Minnesota.
1.2.2 Public Offerings in 1940s
The 1940s brought changes in Northern's regulation and ownership. In 1941, United Light &
Railways sold its share of Northern to the public, and in 1942 Lone Star Gas distributed its
holdings to its stockholders. North American Light & Power would hold on to its stake until
1947, when it sold its shares to underwriters who then offered the stock to the public.
Northern was listed on the New York Stock Exchange that year.
1.2.3 Growth through Acquisitions
Northern continued expanding during the 1970s. During the 1970s, Northern became a
principal investor in the development of the Alaskan pipeline3. When completed, that pipeline
allowed Northern to tap vast natural gas reserves it had acquired in Canada. In 1980,
Northern changed its name to InterNorth, Inc. Over the next few years, company
management extended the scope of the company’s operations by investing in ventures outside
of the natural gas industry, including oil exploration, chemicals, coal mining, and fuel-trading
operations. But the company’s principal focus remained the natural gas industry. In 1985,
InterNorth purchased Houston Natural Gas Company for $2.3 billion. That acquisition
resulted in InterNorth controlling a 40,000-mile network of natural gas pipelines and allowed
it to achieve its long-sought goal of becoming the largest natural gas company in the United
States.
1.2.4 Rename to Enron
In 1986, InterNorth changed its name to Enron. Kenneth Lay, the former chairman of
Houston Natural Gas, emerged as the top
executive of the newly created firm that chose
Houston, Texas, as its corporate headquarters.
Lay quickly adopted the aggressive growth
strategy that had long dominated the
management policies of InterNorth and its
predecessor. Lay hired Jeffrey Skilling to serve
as one of his top subordinates. During the
1990s, Skilling developed and implemented a
plan to transform Enron from a conventional
natural gas supplier into an energy-trading
company that served as an intermediary between producers of energy products, principally
natural gas and electricity, and end users of those commodities. In early 2001, Skilling
assumed Lay’s position as Enron’s chief executive officer (CEO), although Lay retained the
title of chairman of the board.
1.2.5 Enron: Before Collapse
Enron’s 2000 annual report discussed the company’s four principal lines of business. Energy
Wholesale Services ranked as the company’s largest revenue producer. That division’s 60
percent increase in transaction volume during 2000 was fueled by the rapid development of
EnronOnline, a B2B (business-to-business) electronic marketplace for the energy industries
created in late 1999 by Enron. During fiscal 2000 alone, EnronOnline processed more than
3
One of the world's largest pipeline systems. It is 800 miles (1,287 km) pipeline with the diameter of 48 inches
(122 cm) that conveys oil from Prudhoe Bay, to Valdez, Alaska.
8
$335 billion of transactions, easily making Enron the largest e-commerce company in the
world. On the other hand Lay’s position as the chief executive of the nation’s seventh-largest
firm gave him direct access to key political and governmental officials. In June 2001, Skilling
was singled out as “the No. 1 CEO in the entire country,” while Enron was hailed as
“America’s most innovative company. Enron’s chief financial officer (CFO) Andrew Fastow
was recognized for creating the financial infrastructure for one of the nation’s largest and
most complex companies. In 1999, CFO Magazine presented Fastow the Excellence Award
for Capital Structure Management for his “pioneering work on unique financing techniques.”
1.3 Enron’s Corporate Profile
1.3.1 Central Management of Enron Corporation
- Kenneth Lay: Chairman, and Chief executive officer
-
Jeffrey Skilling: President, Chief operating officer, and CEO (February–August 2001)
Andrew Fastow: Chief financial officer
Triton Dietrich: Chief accounting officer
Rebecca Mark-Jusbasche: CEO of Enron International and Azurix
Lou Pai: CEO of Enron Energy Services
Forrest Hoglund: CEO of Enron Oil and Gas
Dennis Ulak: President of Enron Oil and Gas International
Jeffrey Sherrick: President of Enron Global Exploration & Production Inc.
Richard Gallagher: Head of Enron Wholesale Global International Group
Kenneth "Ken" Rice: CEO of Enron Wholesale and Enron Broadband Services
J. Clifford Baxter: CEO of Enron North America
Sherron Watkins: Head of Enron Global Finance
Jim Derrick: Enron General Counsel
Mark Koenig: Head of Enron Investor Relations
Joan Foley: Head of Enron Human Resources
Richard Kinder: President and COO of Enron (1990-December 1996); co-founder of
Kinder Morgan
Greg Whalley: President and COO of Enron (August 2001– Bankruptcy)
Jeff McMahon: CFO of Enron (October 2001-Bankruptcy)
1.3.2 Products of Enron Corporation
Enron traded in more than 30 different products, including the following:






Products traded on EnronOnline
o Petrochemicals
o Plastics
o Power
o Pulp and paper
o Steel
o Weather Risk Management
Oil and LNG transportation
Broadband
Principal investments
Risk management for commodities
Shipping / freight
9


Streaming media
Water and wastewater
1.3.3 Enron’s Financial Performance (1996-2000)
Exhibit: 1 Enron Corporation 2000’s Annual Report Financial Highlight Table
(In millions except per share amount)
1.4 Conclusion
The Enron Scandal is considered to be one of the most notorious within American history. At
the time of Enron's collapse, it was the biggest corporate bankruptcy ever to hit the financial
world. 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.
10
Chapter 02: The Enron Collapse
2.1 The Fall of Enron
In May 2001, Enron’s executive Clifford Baxter left the company, apparently in
uncontroversial circumstances. It was rumored that Baxter, who later committed suicide, had
clashed with Jeff Skilling (Enron’s CEO), over the righteousness of Enron’s partnership
transactions.
On 14th August 2001, Jeff Skilling resigned as Chief Executive, citing personal reasons and
Kenneth Lay became Chief Executive Officer. Skilling’s departure was prompted by
concerns over Enron's bungled accounting and bad management.
In mid August 2001, Sherron Watkins, Enron’s Corporate Development Executive, who was
later referred to as the “whistleblower” in the Enron scandal, wrote a letter to Kenneth Lay
warning him of accounting irregularities that could pose a threat to the company. This
development shocked investors who suddenly panicked. The lack of transparency sent a
selling wave in the market. Investors sold millions of shares, knocking almost $ 4 off the
price to less than $40 over the course of the third week of August 2001. In spite of the drop in
price, management still insisted all was well. Despite the air of impending doom, Kenneth
Lay found two banks willing to extend credit. But the worst of revelations were to come yet.
On 8th November 2001, the company took the highly unusual move of restating its profits for
the past four years. Enron effectively admitted that it had inflated its profits by concealing
debts in its complicated partnership arrangements (Special Purpose Entities).
On 9th November 2001, the humiliation of Enron appeared complete as it entered
negotiations to be taken over by its much smaller rival, Dynegy. The following graph shows
how Enron’s restated accounts.
11
Reported and revised income, debt and shareholder equity 1997 – 2000 following special partnership revelations;
Source: Enron/Powers Special Report
Enron filed for bankruptcy in December 2001 and filed a suit against Dynegy for pulling out
of the proposed merger. Enron’s share price collapsed from around $ 95 to below $ 1.
Enron’s employees lost their savings as well as their jobs. Mr. Kenneth Lay, the once
renowned visionary chairman of the firm, resigned in January 2002.
It appears now that the phenomenal success of Enron was a daydream and it seems to have
sunk into a financial predicament that is largely of its own creation. In just sixteen years,
Enron grew into one of America's largest companies; however, its success was based on
artificially inflated profits, questionable accounting practices and fraud. Several of the
company’s businesses were losing operations; a fact that was concealed from investors using
off balance sheet vehicles or structured finance vehicles.
2.2 Why Enron Fell from Grace
2.2.1 SPE
A special purpose entity, sometimes called a special purpose vehicle, is a legal entity created
for one very limited, particular task. Typically, SPEs are subsidiaries of a larger corporation.
Usually the task of a special purpose entity is to isolate risk. By setting up an SPE dedicated
to the acquisition and financing of specific assets, the parent corporation is protected in case
of bankruptcy, loan default or other loss on those assets. Another use for an SPE is managing
a single asset that has exceptionally complex financial transactions and requires numerous
permits for its operation, such as a factory or a power plant. By placing the asset in the SPE,
it’s easier to keep track of income and expenses associated with this entity. Plus, if the owner
wants to sell the asset, any required permits will transfer with the SPE, eliminating the need
to assign them over separately. This greatly simplifies a potentially difficult sale.
12
2.2.2 Accounting Issue
Enron was one of the first amongst energy companies to begin trading through the internet,
offering a free service that attracted a vast amount of customers. But while Enron boasted
about the value of products that it bought and sold online around $880 billion in just two
years, the company remained silent about whether these trading operations were actually
making any money.
It is believed that Enron began to use sophisticated accounting techniques to keep its share
price high, raise investment against its own assets and stock and maintain the impression of a
highly successful company. These techniques are referred to as aggressive earnings
management techniques Losses from its books if it passed these “assets” to these
partnerships. Equally, investment money flowing into Enron from new partnerships ended up
on the books as profits, even though it was linked to specific ventures that were not yet up
and running. It now appears that Enron used many manipulative accounting practices
especially in transactions with Special Purpose Entities (SPE) to decrease losses, enlarge
profits, and keep debt away from its financial statements in order to enhance its credit rating
and protect its credibility in the market.
The main reason behind these practices was to accomplish favorable financial statement
results, not to achieve economic objectives or transfer risk. These partnerships would have
been considered legal if reported according to present accounting rules or what is known as
“applicable accounting rules”. One of these partnership deals was to distribute Blockbuster
videos by broadband connections. The plan fell through, but Enron had posted $110 million
venture capital cash as profit.
Although these practices were generally disclosed to Enron’s investors, the disclosure was
inadequate. This inadequacy may have stemmed from conflict of interest to avoid revealing,
the extent to which some top Enron executives were enriching themselves, which simply
represents fraud. Another explanation may relate to Enron’s governance whereby Enron’s
structured finance transactions were so complex that disclosure becomes necessarily
imperfect. Therefore Enron’s investors had to rely on their business judgment of Enron’s
management, but such reliance failed due to a tangled web of conflicts of interests. This
becomes crystal clear when it was known that most of the senior Enron executives, especially
13
Andrew Fastow, served as the SPE’s principals, receiving massive amounts of compensation
and returns, in order to skew their loyalty in favor of the SPEs.
2.2.3 The Crash of Enron
The shockwaves of the corporate crash resonated worldwide as investors around the world
demanded answers. Congressional hearings began in December 2001. Four of Enron's most
senior executives (Andrew Fastow, Richard Buy, Michael Kopper and Kenneth Lay) pleaded
Fifth Amendment protection against self-incrimination and refused to testify.
In January 2002, the US department of justice announced a criminal investigation. For the
average layman, the collapse of Enron is a scandal of a major energy provider that used to be
the seventh largest corporation in America and became the biggest bankruptcy in the US
corporate history. As revelations of the Enron affair continue to tumble out, employees and
investors are furious at the way a senior executive behaved and at how auditors, analysts,
banks, rating agencies and regulators turned a blind eye to what was going on.
The Enron fiasco is an unprecedented situation. This was a company with an extraordinary
complex and risky business model that entered into highly questionable transactions. The
market capitalization of Enron had reached exceptional valuations relative to the realism of
the company’s ability to produce recurring excess cash flow. What finally brought the
company down is finalized? Internal policies, investment advisors, investment banks,
undetermined criminal activity, poor auditing, and poor rating probably all played a role in its
rapid demise.
2.2.4 Enron’s Auditor (Arthur Andersen)
Arthur Andersen, one of the world's five leading accounting firms, was Enron’s auditing
firm. This means that Andersen’s job was to check that the company’s accounts were a fair
reflection of what was really going on. As such, Andersen should have been the first line of
defense in the case of any fraud or deception.
Arguments about conflict of interest had been thrown at Andersen since they acted as both
auditors and consultants to Enron. The company earned large fees from its audit work for
Enron and from related work as consultants to the same company. When the scandal broke,
the US government began to investigate the company’s affairs, Andersen’s Chief Auditor for
Enron, David Duncan, ordered the shredding of thousands of documents that might prove
compromising. That was after the Securities and Exchange Commission (SEC) had ordered
an investigation into the speculative actions of Enron. Duncan said he was acting on an e mail
from Nancy Temple, a lawyer at Andersen, but Temple denied giving such advice. While
Andersen fired Duncan, its Chief Executive Officer, Joseph Berardino, insisted that the firm
did not act improperly and could not have detected the fraud. Berardino conceded that an
error of judgment was made in shredding documents, but he still protested Andersen’s
innocence.
14
2.2.5 Links with The Government (Bush Administration)
In spite of the fact that there are no suggestions currently that there were any illegal
connections between the current US administration and Enron officials, there are close links
that exist between Enron and the current administration at all levels whether personal, social,
financial, professional or political. According to reports, thirty five administration officials
have held Enron stock, some had six figure investments. Several, less senior officials, have
served as paid consultants for Enron.
According to the US Center for Public Integrity, Lay (CEO of Enron) and Enron donated
more than $ 500,000 to the Bush campaign, thus making Enron the President’s largest single
patron. Bush has championed some issues Enron considered important, such as deregulating
utilities and limiting compensation awards. Bush has also favored more oil exploration and
drilling in spite of opposition from environmentalists.
As for the US Vice President, Dick Cheney, he is alleged to have met Enron executives four
times in 2001 to discuss energy policy. Cheney’s critics say that no company in the US stood
to gain more from the energy policies than Enron. Later the General Accounting Office, the
investigative arm of the US Congress, demanded that the Vice President releases documents
relating to the formulation of government energy policy but he resisted. It is also known that
Cheney was the former Chief Executive of an oil services company named Halliburton,
which built the Enron Field stadium in Houston, when Mr. Cheney was its Chief Executive.
Paul O’Neil, the current US Treasury Secretary, had been contacted by Lay who asked O'Neil
to encourage US banks to extend their credit to Enron, a request refused by O’Neil. SEC
Chairman Harvey Pitts was hand-picked by Lay for the position, due to his notorious
aversion to governmental regulation of any kind.
2.2.6 The Link of Enron with The British Front
Shock waves of the Enron scandal have been felt in Britain too, where Enron acted as a
sponsor of the two main political parties, Labor and Conservatives. The Labor party was
accused of taking Enron’s money in return for access to government ministers. The party had
apparently changed its policy on gas-fired power stations after being lobbied by companies,
including Enron. This was seen by some as possible evidence of Enron's influence on
government policy. However, the UK Government insists its links with Enron have neither
changed policy nor bought access to ministers. The row has renewed campaigners’ calls for
political parties to be funded by the state rather than relying on business donations.
A second front of allegations emerged over Labor’s close ties with Andersen, Enron’s
accountants, a company barred from government work for failing to prevent the DeLorean
car company collapse. This ban was later lifted, which has caused the rise of awkward
questions faced by the Labor party now. Furthermore, Lord Wakeham, a former Conservative
Cabinet Minister and a nonexecutive director in Enron. Lord Wakeham served on the audit
committee that was meant to oversee Enron’s auditing procedures, which is at the heart of the
scandal, and supposed to protect shareholders’ interests. In response to these allegations,
Lord Wakeham stepped down as Chairman of the Media Watchdog, the Press Complaints
Commission (PCC).
15
2.3 The consequences of Enron Collapse
Enron stands for the greatest company scandal in the history of the US economy and has
become a symbol of corruption for the whole Western economic system.
• 4500 employees lost their jobs.
• Investors lost some 60 billion dollars within a few days; for many it meant losing their oldage security.
• The pension fund for the company's employees was obliterated.
• Citizen’s trust in the American economic system was destroyed.
• Losses on the financial market amounted to the worst stock value loss in peaceful times.
• Banks were suspected of collusion.
• The auditing firm Arthur Anderson lost its accreditation.
• The rules for company financial reporting were drastically sharpened: Sarbanes-Oxley Act
(2002).
• The close ties of the company's founder, Kenneth Lay, to US President George W. Bush –
Lay was an important financial supporter of Bush – came under sharp criticism
2.3.1 The Victim: Employees and Pension Fund Holders
The collapse of Enron has left thousands of people out of work. Thousands lost their personal
investments and pensions after the scandal broke out and Enron's stock plunged. Many
employees had personal pension funds made up of Enron shares - a common situation in
America, where occupational schemes based on final salary payments are increasingly rare
and money purchase schemes, known as 401(K) plans, are the norm. Employees at Enron
were encouraged to do so by the company, which also forbade them from selling their stocks,
when the company share price came down. In contrast, many Enron executives were able to
cash in their share options when the company’s fate became clear.
2.3.2 Creation of Sarbanes-Oxley Act
In response to the auditing and accounting problems laid bare by Enron and other corporate
scandals, Congress enacted the Sarbanes-Oxley Act of 2002 (P.L. 107-204), containing
perhaps the most far-reaching amendments to the securities laws since the 1930s. Very
briefly, the Act does the following:

Creates a new oversight board to regulate independent auditors of publicly traded
companies – a private sector entity operating under the oversight of the Securities and
Exchange Commission;
16

raises standards of auditor independence by prohibiting auditors from providing
certain consulting services to their audit clients and requiring preapproval by the
client’s board of directors for other non-audit services;

Requires top corporate management and audit committees to assume more direct
responsibility for the accuracy of financial statements;

Enhances disclosure requirements for certain transactions, such as stock sales by
corporate insiders, transactions with unconsolidated subsidiaries, and other significant
events that may require “real-time” disclosure;

Directs the SEC to adopt rules to prevent conflicts of interest that affect the
objectivity of stock analysts;

Authorizes $776 million for the SEC in FY 2003 (versus $469 million in the
Administration’s budget request) and requires the SEC to review corporate financial
reports more frequently; and

Establishes and/or increases criminal penalties for a variety of offenses related to
securities fraud, including misleading an auditor, mail and wire fraud, and destruction
of records.
2.4 Punishment
Kenneth Lay
 Born April 15, 1942
Tyrone, Missouri, USA
 Died July 5, 2006
 Conviction(s) fraud, false statement
 Penalty died before sentencing, conviction vacated
 Status died of a heart attack before his sentencing
Jeffrey Skilling
 Born November 25, 1953
 Conviction(s) conspiracy, securities fraud, false statement, insider trading
 Penalty imprisoned 24 years and 4 months, fined $45 million
 Status in prison
 Occupation prisoner/Failed Businessman
 Spouse Rebecca Carter
17
Andrew Fastow
 On October 31, 2002, Fastow was indicted by a federal grand jury in Houston, Texas
on 78 counts including fraud, money laundering, and conspiracy.
 On January 14, 2004, he pled guilty to two counts of wire and securities fraud, and
agreed to serve a ten-year prison sentence.
 He also agreed to become an informant and cooperate with federal authorities in the
prosecutions of other former Enron executives in order to receive a reduced sentence.
As of November 2006, Fastow is Inmate #14343-179 at the Federal Detention Center
(FDC) in Oakdale, Louisiana, with a projected release date of December 17, 2011
David Duncan
 Jan. 10, 2002: Arthur Andersen says its employees destroyed a "significant but
undetermined“ number of Enron documents
 David Duncan were cited as the responsible managers in this scandal as they had
given the order to shred relevant documents
 On April 9, 2002 he pleaded guilty; the maximum sentence for his crimes is ten years,
but since he pleaded guilty and became a witness for the prosecution he would have
presumably received a much smaller sentence.
The final blows came when Andersen was banned from US government work after being
indicted by a federal grand jury on the charge of obstruction of justice. This was coupled with
the case brought by the US Department of Justice against the Andersen UK office for joining
in the shredding of Enron documents. This caused Andersen UK practices to reopen merger
talks with other accounting firms in response to these claims made against the office. Both
KPMG and Deloitte had been interested in Andersen's UK business, but KPMG's interest
trailed off as more information became available about Andersen's financial situation and the
potential risk of litigation. Andersen UK agreed to join with Deloitte, Touché & Tohmatsu. In
addition, Deloitte reached agreements with Andersen partners in Spain, Portugal, the US and
Mexico.
2.5 What then is the Solution?
If there is any good that came from a situation like Enron, it’s that collectively as an investing
public, we are better versed on accounting fraud of this nature. The financial markets, the
analysts, the Securities and Exchange Commission, and the public accountants have all by
now absorbed many of the intricacies of SPE abuse. In short, we now know for what to look
and efforts an be focused accordingly. So how do we prevent another Enron from happening
again? The standard-setters and the gatekeepers, in spite of all the accounting and disclosure
reform, need to appreciate with what they are dealing. A deficiency or a perceived deficiency
in the accounting rules is not the problem. The problem is persons that seek to obfuscate,
omit, and fraudulently report financial information. Accordingly focus on ferreting out SPE
abuse should be primarily placed on the abusers themselves, not the SPEs formed to
perpetrate such abuse. Wide spread legislation and accounting reform merely casts a broad
net with the hopes that the abusers will get snared along with the rest of the fish.
18
But in the meantime those fish are burdened with the added cost of complex and complicated
compliance when they weren’t doing anything wrong under the old regime nor had problems
complying under the old regime.
So what is the alternative? The forefront of the approach should be a narrow and isolated
focus on SPE abusers. Although the matter has not been completely resolved, the evidence
suggests that actual SPE abusers represent a small pool of companies relative to the total
population of public companies. This could be achieved by the SEC and or other related gatekeepers taking a “risk-based” approach toward the problem. First, the gatekeepers should
narrow its scope by first focusing on those companies’ or industries that lend themselves or
could potentially lend themselves toward SPE abuse.
Those industries that tend to deal heavily in derivatives, intangible assets such as the buying
and selling of futures contracts, etc. would be good places to start. Additionally, those
industries or companies that stand to come under earnings pressure, i.e. having trouble
reaching financial forecasts or earnings targets, or seem to be engaging in creative ways at
maintaining earnings and revenue growth. The overarching idea is that since we have seen it
before (ala Enron), that accumulated knowledge is taken and applied going forward. It could
very well be possible that in terms of SPE abuse, the proprietary abuse that Enron perpetrated
was a local and isolated event. The SEC Report, though useful in the information it
contained, did little to address the question of whether or not there is widespread SPE and
off-balance sheet abuse. The Report merely focused on SPE and off-balance sheet use, which
is helpful but doesn’t tell the whole story nor tell the most important part of the story.
With all of this collective knowledge and insight as to the accounting fraud that Enron
perpetrated, it is reasonable to conclude that the SEC could derive some sort of search criteria
or “corporate profiling” of either industries or particular companies that show indicia for
potential SPE abuse. Those companies could then be targeted and special attention and focus
could be placed on those companies. Understand that the initial stages of such action would
be non-intrusive. The initial stages of the focus would merely involve a close and scrutinizing
look at those companies’ annual and periodic reports for evidence of SPE abuse or any other
type of financial reporting irregularities.
If such scrutiny raises red flags then the SEC could then perform an escalated inquiry into the
matter. If the escalated inquiry yields problematic accounting, then the next step would be for
the SEC to initiate a more aggressive fact finding inquiry. If accounting irregularities are
found, the indictment, prosecution and ultimate conviction should be a high profile event.
Such would then send a clear and unequivocal message to other similarly situated offenders
to make the proper adjustments in their financial reporting or face the same fate.
2.6 Conclusion
The issues dealt with in this paper are complex and trying to resolve these issues pose an
even greater challenge. But before real effective change can be achieved, we must first be
able to target the root of the problem. Complex problems tend to involve complex solutions.
The band-aid of legislation, more guidance, or “clearer” guidance if you will, will more than
likely result in nothing more than the tug and pull between standard-setters and issuers to
continue along this “move”, “countermove” approach that has gotten us to where we are
today. Until we are able to focus more narrowly on the problem and deal with it from that
more directed approach, we’ll probably be seeing more of the same. Better mousetrap, better
mouse.
19
Chapter: 03 Case Questions Solution
3.1 Questions & Solutions of Case 1.1 Enron Corporation of ‘Auditing Cases by Knapp’:
Q#1. The Enron debacle created what one public official reported was a “crisis of
confidence” on the part of the public in the accounting profession. List the parties who
you believe are the most responsible for that crisis. Briefly justify each of your choices.
Solution:
Executives of Enron - Kenneth Lay, Jeffery Skilling, and Andrew Fastow were all
responsible for the crisis. The executives of Enron orchestrated the big earnings and pushed
up the stock prices for their own benefit. When misstatements and irregularities emerged and
were made clear to the public, the executives of Enron lost the confidence of the stakeholders
in the company and the crisis of confidence spread.
Arthur Andersen - The auditing firm did not present itself with the professionalism and
responsibility that an audit firm should. When the firm noticed that the amounts recorded on
Enron’s financial statements were misstated, it was ignored in order to continue receiving the
enormous amounts of fees and payments from the corporation. In doing so, the confidence
that the public had in the company was diminished.
SEC - The government agency who allowed Enron to use Mark-to-Market Accounting
practice. This kind of creative accounting practice allowed the Enron CEO to perform his
Ponzi scheme “legally” and led to the sudden collapse of Enron.
Q#2. List three types of consulting services that audit firms have provided to their audit
clients in recent years. For each item, indicate the specific threats, if any, that the
provision of the given service can pose for an audit form’s independence.
Solution:
“Internal Auditing” should be conducted within a company instead of having an outside audit
firm to perform the service. If an outside audit firm was hired then it will present a threat to
the legitimacy of the internal audits.
An audit firm should not be “Designing Accounting Systems” for a firm while performing
audit services to the same firm. It is too easy for the audit firm to alter the accounting systems
within a company, an auditor can fabricate the financial situations of a corporation and make
it appears to be more profitable or more attractive to investors.
An outside audit firm should not provide “Professional Consulting” and auditing service to a
same company. Auditors involved in the dealings of a business are at risk for becoming
subjective to the success of that organization. When an auditor is involved in such
20
happenings, they are not able to perform their duties as an external auditor to the best of their
ability. Their opinions are subject to change based on biases.
Q#3. For purposes of the question, assume that the excerpts from the Powers Report
provide accurate descriptions of Andersen’s involvement in Enron’s accounting and
financial reporting decisions. Given this assumption, do you believe that Andersen’s
involvement in those decisions violated any professional auditing standards? If so, list
those standards and briefly explain your rationale.
Solution:
Yes, Andersen’s involvement in the accounting and financial reporting decisions violated
professional auditing standards of the independence in mental attitude. Andersen’s interests
were not independent of the company, but the audit firm invested themselves in solidifying
the security of the company and its success.
The significant amount of earnings that Andersen received when performing accounting
services to Enron goes against auditing standards.
Q#4. Briefly describe the key requirements included in professional auditing standards
regarding the preparation and retention of audit workpapers. Which party “owns”
audit workpapers: the client or the audit firm?
Solution:
The key requirements included in professional auditing standards regarding the preparation
and retention of audit workpapers are:
i) The auditor must state in the auditor’s report whether the financial statements are presented
in accordance with GAAP.
ii) The auditor must bring to light an instances in which the GAAP were not consistent during
the current period.
iii) When informative disclosures are not adequate, the auditor must state so in the report.
iv) The auditor must state an opinion in regards to the financial statements. If the auditor
cannot state an opinion, this much be noted in the report. If the auditor is taking any
responsibility in relation to the financial statements, it must also be stated in the auditor’s
report.
The audit workpapers belong to auditing firm. The auditor does hold responsibility for the
evidence and reports, and is to make sure that the information is not misused in any way.
21
Q#5. Identify and list five recommendations that have been made recently to strengthen
the independent audit function. For each of these recommendations, indicate why you
support or do not support the given measure.
Solution:
i) Revise the rules related to the non-audit services that, if provided to an audit client, would
impair an accounting firm's independence.
Support; independence is the key in performing an audit.
ii) Require the auditor to report certain matters to the issuer's audit committee, including
"critical" accounting policies used by the issuer.
Support; in many cases, the internal auditors need to have access to the information that
external audit firms happen upon.
iii) Require the issuer's audit committee to pre-approve all audit and non-audit services
provided to the issuer by the auditor.
Support; the audit committee should know beforehand what the auditor will be providing for
the company.
iv) Require disclosures to investors of information related to audit and non-audit services
provided by, and fees paid to, the auditor.
Support; the cost of audit should be disclosed. An abnormal high audit fees is also an
indicator of “something doesn’t smell right”.
v) Establish rules that an accounting firm would not be independent if certain members of
management of that issuer had been members of the accounting firm's audit engagement team
within the one-year period preceding the commencement of audit procedures.
Support; this allows the accounting and auditing teams to remain separate in their powers.
Q#6. Do you believe that there has been a significant shift or evolution over the past
several decades in the concept of “professionalism” as it relates to the public accounting
discipline? If so, explain how you believe that concept has changed or evolved over that
time frame and identify the key factors responsible for any apparent changes.
Solution:
Yes, I believe that there has been a significant shift over the past several decades, in which it
has occurred towards a standpoint via setting up standards and regulations which allows
accountants and auditors to be more accountable for their work. Key factors in this evolution
are laws, regulations, and the implantation of GAAP and GAAS.
22
Q#7. As pointed out in this case, the SEC does not require public companies to have
their quarterly financial statements audited. What responsibilities, if any, do audit firms
have with regard to the quarterly financial statements of their clients? In your opinion,
should quarterly financial statements be audited? Defend your answer.
Solution:
I believe that it is the responsibility of an auditor to examine quarterly statements during a
yearly audit. An auditor should always be skepticism when performing audit service to any
client. If an audit was done quarterly on a company opposed to yearly, and misstatements and
fabrications would appear sooner to an audit firm.
3.2 Conclusion
Fraudulent accounting techniques allowed Enron to be listed as the seventh largest company
in the United States and it was expected to dominate the trading it had virtually invented in
communications, power, and weather securities. Instead, it became the largest corporate
scandal in history, and became emblematic of institutionalized and well-planned corporate
fraud. After a series of scandals involving irregular accounting procedures bordering on fraud
involving Enron and its accounting firm Arthur Andersen, it stood at the verge of undergoing
the largest bankruptcy in history. During 2001, Enron shares fell from US$85 to US$0.30. As
Enron was considered a blue chip stock, this was an unprecedented and disastrous event in
the financial world. Enron's plunge occurred after it was revealed that many of its profits and
revenue were the result of deals with special purpose entities. The Enron scandal is extremely
rich in lessons. The most important lesson is the understanding that the fraudulent
accounting was not the cause of the scandal, but the consequence of how Enron was
governed. In other words, the root of the problem was not the accounting manipulation,
which has just been a consequence of collective failures by a wide range of internal and
external agents. The Enron case should be viewed as an opportunity to prevent other ill
governed companies from causing similar losses to investors and society.
23