Instructor’s Manual, Chapter 2
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Business & Professional Ethics
for Directors, Executives &
Accountants, 5e,
Leonard J. Brooks and Paul Dunn
South-Western, Cengage Learning, Mason Ohio, 2010
Instructor’s Manual
Chapter 2 Enron Events Motivate Governance & Ethics Reform
Learning objectives ………………………………………………………2
Possible teaching approaches, using cases and readings…………………3
Answers to questions for discussion…………………………………….. 4
Case Notes………………………………………………………………. 7
Multiple Choice Questions………………………………………………23
PowerPoints are in a separate file at www.cengage.com/accounting/brooks
Business & Professional Ethics for Directors, Executives & Accountants, 5e,
L.J. Brooks & P. Dunn, Cengage Learning, 2010
Instructor’s Manual, Chapter 2
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COMMENTARY ON CHAPTER 2:
GOVERNANCE, ACCOUNTING AND AUDITING, POST-ENRON
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Learning Objectives
Chapter 2 is designed to review the Enron, Arthur Andersen and WorldCom fiascoes to reveal:
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How fraudulent transaction were arranged and carried out,
How flaws in the following permitted and facilitated these transactions:
 Focus of accountability,
 Governance perspective, understanding and mechanisms including the corporate
culture involved,
 Motivation systems, including remuneration, stock option and bonus systems
 Understanding of roles, risks and mandates for:
 Directors and executives
 Professional accountants
 Lawyers
 Bankers who facilitated these transactions
What the impacts have been and will be on these corporate and professional
participants due to:
 Reactions by government and regulatory agencies
 The Sarbanes-Oxley Act of 2002
 Resulting SEC, NYSE and OSC securities and governance regulations
The New Framework for Accountability and Governance
Future developments that are likely
In addition, two other cases – involving Waste Management, Inc. and Sunbeam Corporation - are
presented that further illustrate these patterns of flaws in Arthur Andersen’s approach and clients.
Important learning points to be developed include:
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An understanding of:
 what happened and what permitted it to happen
 appropriate roles to be played by directors, external and internal professional
accountants, lawyers, executives, and so on
 appropriate mandates to be accepted by corporations (including banks) and
professionals based upon stakeholder expectations
 the new expectations for accountability and governance to facilitate that
accountability for both corporations and the accounting profession, including the
changes required by the Sarbanes-Oxley Act and introduced by the SEC and how
these will have a ripple affect around the world.
 how formal risk management programs might have raided the potential ethics
problems that arose
 how Arthur Andersen’s demise changed the probability and cost impact of a
Business & Professional Ethics for Directors, Executives & Accountants, 5e,
L.J. Brooks & P. Dunn, Cengage Learning, 2010
Instructor’s Manual, Chapter 2
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“franchise risk” (one that threatens to end or curtail an operating mandate)
 likely future developments
 appropriate safeguards to avoid situations arising if the following assumptions
turned out to be false.
How and why the following assumptions turned out to be false:
 People can be trusted to act honestly without follow-up
 Dishonesty in some aspects of corporate activity will not affect basic overall
integrity or accountability
 Incentive compensation schemes are good enough to cause employees to act in
the best interests of shareholders (and therefore stakeholders) (i.e. agents will be
free of moral hazards)
 The Board of Directors:
 would be told the truth by management, lawyers and professional accountants
 understood why policies and a system of governance/internal controls that
ensured compliance was necessary
 understood what the system of governance/internal should be and how it
should work, including the role of the internal auditor
 could rely upon the system of governance/internal controls without follow-up
or review.
 Ethical concerns of whistleblowers would be reported and acted upon by
management and/or brought to attention of the Board
 Making quarterly profits was all that mattered, and would lead to sustained
success
Possible teaching approaches, using cases and readings
My approach to the material in this chapter is as follows:
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Students should read the chapter in advance, but unless they are senior accounting students
they should be told not to slave over the accounting details.
I start with a short overview discussion on governance to get the students to consider the role
and responsibilities of directors and of executives, as well as of external auditors and lawyers
Then I ask the students to assume they are Enron Board members and ask themselves what
questions they should be asking as I present overheads that lead the students through the
Enron, Arthur Andersen and WorldCom material including the bare bones of questionable
acts such as those with SPEs.
I continually challenge the students as to what they would ask, and why the Enron Board
didn’t. For example:
 did they understand Enron’s business model and where the profits were coming from?
It was from the wholesale division, and mostly from the Special Purpose Entities
(SPEs)
 how many SPEs existed and why? It was in the thousands!!
 Why didn’t they know about the incredibly high stock option payments being made?
 Why didn’t more whistleblowers come forward, and why didn’t their concerns reach
Business & Professional Ethics for Directors, Executives & Accountants, 5e,
L.J. Brooks & P. Dunn, Cengage Learning, 2010
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the board?
What could motivate the fraudulent behavior by Enron executives? Greed – see the
stock option payouts and SPE guarantees, both of which required Enron stock not to
fall.
Was it OK for the banks to facilitate the Prepaid transactions when they knew the
transactions had no economic substance?
Were Enron’s tax avoidance schemes OK? Will there be fallout for the advisors?
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I then move on to discuss the Arthur Andersen case and its impact on the accounting
profession.
I review the WorldCom case show how it galvanized action in the U.S. Congress and Senate
leading to SOX.
Finally, I review the impacts of SOX on corporate accountability and governance, and well
as on the accounting profession.
PowerPoints are available on my website.
Answers to Questions for Discussion
The following questions are posed at the end of the chapter.
1. What were the common aspects that were necessary for the Enron and WorldCom debacles
to occur?
In both cases, there was a dominant CEO who also controlled the Board of Directors.
The Chair of the Board did not serve as an effective watchdog over the CEOs activities.
In addition, senior financial officers were actively engaged in the manipulation of
earnings and assets, and the siphoning off of funds for personal use, all to defraud the
company. In each case, company policies and related internal controls of the company
were suspended or over-ridden, and the Board was too trusting or too ignorant to ask the
right questions. External auditors (Arthur Andersen in both cases) were willing to go
along with manipulative entries and overstatements presumably to retain lucrative audit
clients and consulting assignments. In so doing, they put aside the interests of the
investing public and jeopardized pensions and employees’ interests. Finally, directors
were apparently unaware of mounting problems because they were kept in the dark, and
no whistle-blowers concerns were brought to them.
2. What actions by directors, executives and professional accountants could have prevented the
Enron and WorldCom debacles?
Directors should have reviewed policies for conflicts of interest and followed up on
compliance with them using reports from internal audit and other sources. As a normal
practice, they should have reviewed payments to employees and directors for stock
options and other items for reasonability. Also they should have taken steps to create and
ensure an ethical corporate culture, complete with a protected whistle-blowing
mechanism. Executives could have spoken directly to Board members, or to the media,
or used the False Claims Act – see Singer article. Professional accountants could have
done the same, plus reported to the Audit Committee of the board, or to Arthur Andersen
Business & Professional Ethics for Directors, Executives & Accountants, 5e,
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in writing. Arthur Andersen, of course, should have been more vigilant on SPE
transactions, and should have refused to allow manipulative transactions without
qualification of the audit opinion. They should have reported fully to the Audit
Committee. In addition, they should have had more effective conflict of interest rules,
and should not have permitted lure of revenue generation to overshadow their duty to the
public interest.
3. Was the enactment of the Sarbanes-Oxley Act (SOX) necessary? Why or why not?
I would say “yes” because the following patterns were too entrenched to be altered
quickly without SOX, and the lack of credibility of and trust in the capital markets, and in
turn in corporate accountability and governance, demanded a quick remedy:
 Manipulation of financial reports to “smooth” earnings
 Enormous remuneration for top executives, particularly with stock options
 Lack of effective governance by Boards of Directors, due to:
 Lack of understanding
 Failure to accept responsibility
 Lack of competence
 Lack of effective legal penalties for executive and director malfeasance
 Rampant conflicts of interest in the public accounting profession
 Failure of public accounting profession to serve the public interest
The negative side could be argued – that the market should be allowed to self-correct, but
the correction would be slow, and the players would be reluctant to give up their
positions of advantage. In the end, self-regulation produced the debacle, so far-reaching,
quick readjustments would be an unlikely possibility.
4. What are the three most important improvements in the governance structure that could result
from the SOX?
It will take some time to know for sure, but the following are likely to be high on the list:
 Requiring directors on key committees (audit and nominating) to be
independent and competent
 Establishing direct criminal liability on the part of the CEO and CFO for
manipulations and/or failure to have appropriate control systems in place who
must sign the quarterly financial reports asserting to both
 Enhanced independence of external auditors
 Ensuring that the Audit Committee has unfettered access to auditors and their
discussions with management
 Ensuring that whistleblowers have a path to the Audit Committee
5. What were the common elements in Arthur Andersen’s approach that appeared to allow the
disasters at Enron, WorldCom, Waste management, and Sunbeam?
Within Arthur Andersen, the audit partner responsible for each audit had the power to
veto or ignore the recommendations of the quality control partner. Consequently, the
ongoing pressure for more audit and consulting revenue (and take-home remuneration
particularly for the audit partner) appears to have caused the audit partner in charge at
each client cited to ignore warnings that could have prevented manipulations and the
Business & Professional Ethics for Directors, Executives & Accountants, 5e,
L.J. Brooks & P. Dunn, Cengage Learning, 2010
Instructor’s Manual, Chapter 2
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disasters. Pressure to retain and enhance revenue was also exerted by those managing the
practice.
6. What is wrong with Enron’s banks financing transactions they knew were without economic
substance?
With hindsight, Enron’s banks should have realized that they were becoming accessories
to the crime of misleading investors. If there was no legitimate financial purpose, then
they were facilitating something else. In the future, they will be more careful in assessing
their mandates and why they are in some business deals. As articulated in the chapter,
the banks have paid huge fines for aiding and abetting in the Enron fraud, and will be
stiffening up their due diligence protocols in the future.
7. How should Boards of Directors change incentive remuneration schemes for executives to
lessen the risk of motivating executives to risk manipulations to enrich themselves?
There should be less emphasis on short-term performance and on stock options where
their value depends upon stock price rather than fundamental indicators of performance
that are less susceptible to manipulation. Deferred payouts, concentration on cash
payouts, remuneration schemes that have negative provisions for poor performance, and
constant review and readjustment are all good ideas for a board to consider. Finally, the
Compensation Committee of the Board should be independent of management so that
decisions can be free of bias.
8. What lessons should be learned from reviewing the events described in this chapter?
See the above list of learning points and false assumptions for Chapter 2.
Business & Professional Ethics for Directors, Executives & Accountants, 5e,
L.J. Brooks & P. Dunn, Cengage Learning, 2010
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ENRON DEBACLE – ENRON’S QUESTIONABLE
TRANSACTIONS
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What this case has to offer
The Enron Debacle is the icon for massive fraud allowed by failure of the company’s governance
system and the conflicted interests of its executives, auditors and lawyers. It precipitated the loss
of credibility and trust in financial markets and corporate governance and accountability that
ultimately led to reform of corporate governance and accountability, and of the accounting
profession, through the Sarbanes-Oxley Act of 2002. It is a case that all businesspeople and
professional accountants should be familiar with and understand.
Teaching suggestions
I use the PowerPoint slides on my website for instructors. First, I set up the topic of governance;
second, I use “Enron Affair” to review the important elements of the case; and finally I use
“Enron Debrief” to debrief, and review the rest of the material in Chapter 2 and models used in
the course.
If you refer to the “Enron Affair” PowerPoints, you will see the order I have found to be very
engaging and successful. I ask the audience to assume the role of a member of the Board of
Directors, and then I challenge them throughout the case discussion with the following questions:
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What is your role as a Board member?
What questions should you ask?
Why didn’t the Enron Board ask those questions?
Depending on the audience (non-accounting or accounting), I review less or more of the details
of the fraudulent transactions. My PowerPoints provide a basic set. The key is to reveal enough
that all audiences understand:
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Basic governance structure and roles of the Board, executives, professional
accountants and lawyers, as well company policy (particularly on conflicts of interest)
and compliance systems.
What a Special Purpose Entity (SPE) is, the operation of the 3% rule for accounting
for transactions, and how income, assets and liabilities could be manipulated using it.
How and by whom the basic frauds were committed.
Business & Professional Ethics for Directors, Executives & Accountants, 5e,
L.J. Brooks & P. Dunn, Cengage Learning, 2010
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The motivation for the frauds.
Where the money went.
What the impact of manipulation was on Enron’s financial reports, and the investing
public.
How the governance system was short-circuited – see overheads.
The role of an ethical or unethical corporate culture in preventing or abetting fraud.
Why whistle-blowing is important.
What Arthur Andersen contributed.
What the banks contributed by facilitating the SPE transactions?
How the Sarbanes-Oxley (SOX) Act arose.
What changes SOX originated.
How ethics risk management can help.
Discussion of ethical issues
The following questions are presented in the text for discussion of the significant issues raised in
the Enron case:
1. Which segment of its operations got Enron into difficulties?
Wholesale services was the segment where most of the manipulation went on. See Enron
PowerPoint (PPT) 6 for a breakdown of the relative profitability (IBIT) of Enron’s
divisions.
2. How were profits made in that segment of operations (i.e. what was the business model)?
See PPTs 5 and 7 for a word version of activities – not how hard it is to understand.
Transparency was not in the interest of Enron’s perpetrators.
3. Did Enron’s directors understand how profits were being made in this segment? Why not?
Apparently they did not. They should have queried how almost 50% (See PPT 16 for the
proportion of manipulated income) of Enron’s profits could have come from SPEs whose
operations had no economic substance, or that asset sales and repurchase transactions
between Enron and the SPEs were circular. You can’t make money off yourself. Also,
there were apparently 1,000-3,000 SPEs created, and a good Director should wonder why
so many were needed.
4. Enron’s directors realized that Enron’s conflict of interests policy would be violated by
Fastow’s proposed SPE management and operating arrangements because they proposed
alternative oversight measures. What was wrong with their alternatives?
The Board’s alternative controls were left to Fastow to institute, oversee and presumably
report upon to the Board. He was the principal fraudster, and there was no internal audit
follow-up (Arthur Andersen had taken the internal audit role as a subcontractor), nor did
the Board demand feedback. No whistle-blower concerns reached the independent
member of the Board. Like mushrooms, independent Board members were left in the
dark.
Business & Professional Ethics for Directors, Executives & Accountants, 5e,
L.J. Brooks & P. Dunn, Cengage Learning, 2010
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5. Ken Lay was the Chair of the Board and the CEO for much of the time. How did this
probably contribute to the lack of proper governance?
“Kenny Boy” did not serve as a useful foil or overseer of his own CEO actions, as a good
independent Chair of the Board should. The inherent conflict of interests in being CEO
and Chair has led to increasing separation of these functions as a measure of good
governance, and some jurisdictions are requiring it. For example, Lay’s handling of the
Sherron Watkins whistle-blowing letter showed either brilliance or evidence of
incompetence on conflict of interest matters. He asked the lawyers who advised on
creation of the SPEs if what they had done was all right.
6. What aspects of the Enron governance system failed to work properly, and why?
See PPTs 2, 11, 12, 17 and 19 to focus the discussion. See also Fig. 2.4. of the text.
7. Why didn’t more whistleblowers come forward, and why didn’t some make a significant
difference? How could whistleblowers have been encouraged?
See PPT 19. If you were contemplating coming forward, and you knew that Enron’s
culture was unethical (see examples) and the bosses knew it, would you come forward –
not likely because the risk was too high that you would be fired or not welcomed. There
would have to be changes in the culture and systems to encourage whistle-blowers to
come forward, such as measures to make the culture ethical (see text discussion, and a
protected whistle-blower program. As a result of this apparent flaw, SOX/SEC has
subsequently mandated that all SEC registrant companies have a whistle-blower system
that reports to the Audit Committee.
8. What should the internal auditors have done that might have assisted the directors.
They should have been alert for flaws in Enron’s conflict of interest policies, and any
lack of compliance. When a policy was/is set aside by the Board, internal audit should
have been advised or should have realized this by screening the relevant minutes. Also
they should have been looking for any transactions with questionable economic
substance. Their reports should go the Board of Directors as well as management.
9. What conflict of interests situations can you identify in:
 SPE activities
 Arthur Andersen’s activities
 executive activities.
The Enron Debacle shows conflicts of self-interest (personal gain of executives,
employees, auditors, lawyers, bankers and directors) vs. shareholder (as many were
misled and lost significantly) and other stakeholder interests (as the company objectives
were not met and jobs etc, were lost. Each type of conflict has many examples.
An interesting additional discussion, is how each conflict of interest situation developed,
and why the professionals and directors lost sight of their need for independence, and
what the professional accountants and banker thought that their mandate really was.
Business & Professional Ethics for Directors, Executives & Accountants, 5e,
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10. How much time should a director of Enron have been spending on Enron matters each
month? How many large company boards should a director serve on?
This depends on the complexity of the company’s operations, the competence and trust
placed in its management and governance systems, and the competence and skills of the
Board member. On a company of significant size, a Director may have to spend 4-5 days
per month to discharge their duties properly. On this basis, allowing for personal
business, a person who serves only as a director could only serve on 3-4 Boards.
11. How would you characterize Enron’s corporate culture? How did it contribute to the
disaster?
Enron’s corporate culture was unethical (see PPTs 17 and onward). It was fraught with conflicts
of interest, unethical and also illegal and acts, poor examples were set by directors
and executives, and the directors, professional accountants and lawyers involved
were self-interested instead of in the sustainable interest of shareholders and other
stakeholders. If the process of allowing the satisfaction individual self-interest of
the company’s directors, personnel and agents, they ignored their fiduciary duty
to the shareholders and other stakeholders. The Board members who were
independent of management and not conflicted, were in the dark. Measures to
make a corporate ethical culture are discussed in the text and Chapter PPTs. This
set introduces ethics risk management and other governance and accountability
paradigm changes.
Subsequent Events
May 25, 2006. “Enron Verdict: Ken Lay Guilty on All Counts, Skilling on 19 Counts”, by Gina
Sunseri and Sylvie Rottman, ABC News, download from
http://abcnews.go.com/Business/LegalCenter/story?id=2003728&page=1
“Lay, 64, was convicted on all six counts against him, including conspiracy to commit securities
and wire fraud. He faces a maximum of 45 years in prison. Lay also faces 120 years in prison in
a separate case.
Lay posted a $5 million bond secured with family-owned properties at a hearing following the
verdict. He was ordered to stay in the Southern District of Texas or Colorado.
"I firmly believe I'm innocent of the charges against me," Lay said following the hearing. "We
believe that God in fact is in control and indeed he does work all things for good for those who
love the lord."
Skilling, 52, was convicted on 19 counts of conspiracy and fraud. Combined with his conviction
on one count of insider trading, he faces a maximum of 185 years in prison. Skilling was
acquitted of nine other charges relating to insider trading.
"Obviously, I'm disappointed," Skilling told reporters outside the courthouse. "But that's the way
the system works."
"I think we fought a good fight — some things work, some things don't," he said.”
Business & Professional Ethics for Directors, Executives & Accountants, 5e,
L.J. Brooks & P. Dunn, Cengage Learning, 2010
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“In a separate, nonjury bank fraud trial related to Lay's personal banking, U.S. District Judge Sim
Lake found the Enron founder guilty of bank fraud and making false statements to banks. Lake
had withheld his verdict in the Lay bank fraud case until the Lay-Skilling jury announced its
verdict. Lay faces up to 120 years in prison in that case.”
See also:
http://en.wikipedia.org/wiki/Enron_scandal
Film: Enron: The Smartest Guys in the Room (2005) available on DVD from Alliance Atlantis
Time Enron Scandal webpage at http://www.time.com/time/2002/enron/
Google search for Enron Scandal and related searches at the bottom of the page
Business & Professional Ethics for Directors, Executives & Accountants, 5e,
L.J. Brooks & P. Dunn, Cengage Learning, 2010
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ARTHUR ANDERSEN’S TROUBLES
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What this case has to offer
Arthur Andersen (AA) will forever be a key part of the Enron SOX chain that accelerated
changes in the accountability and governance paradigm for corporations and the accounting
profession. In fact, AA’s problems were systemic as their root was in the firm’s flawed
governance system where the desire for profit was allowed to outweigh the firm’s fiduciary
interests to client shareholders and the public interest. The case presents excellent opportunities
to review conflict of interest issues, the need for inclusion of ethics in an organization’s strategy,
operations and compliance processes, and for illustrating how the expectations of the public can
dramatically affect an organization. AA’s disappearance dramatically illustrates how risk
managers had been in the habit placed too low a value on loosing the ability to operate – known
as “franchise risk”. Post-Enron and AA that valuation has changed upward considerably.
Teaching suggestions
I use the AA PPTs (13-22) in the “Enron Affair” set to discuss the case. The key issues are:
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What happened and who did it?
The 3% SPE accounting rule and how it led to manipulation.
How following the 3% rule precisely, and ignoring the overall principle that there
must be external validity (an independent outside buyer/seller) to allow the recording
of profit, led to manipulation.
What the flaw was in AAA’s governance system that permitted the Enron,
WorldCom, Waste Management and Sunbeam fiascoes?
Other matters raised in the questions below.
Discussion of ethical issues
The following questions reveal the key points of the case:
1. What did Arthur Andersen contribute to the Enron disaster?
AA failed to protect the interest of current and future shareholders, and stakeholders that relied
upon the financial reports and integrity of the company. AA failed to form a
reliable part of the Enron governance system, thereby leaving the directors and
other stakeholders at risk. See the list of AA’s apparent mistakes in the case.
2. What Arthur Andersen decisions were faulty?
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See list of AA’s apparent mistakes in the text, as well as the section on AA’s internal control
flaw.
3. What was the prime motivation behind the decisions of Arthur Andersen’s audit partners on
the Enron, WorldCom, Waste Management, and Sunbeam audits – the public interest or …?
Cite examples that reveal this motivation.
It was revenue generation and retention. They served their self-interest rather than the public
interest by not acting upon the memos from their quality control personnel, and
not challenging the manipulative practices and structures at Enron.
4. Why should an auditor make decisions in the public interest rather than in the interest of
management or current shareholders?
An auditor is the agent of the shareholders, and is elected annually at the Annual general
Meeting of Shareholders by the shareholders. As such, the auditor must make
sure that audited annual financial statements comply with GAAP, and GAAP are
designed to produce statements that do not favor the interests of current
shareholders or executives and mislead future shareholders and other stakeholders
such as governments, taxing authorities and the like. GAAP is therefore designed
to produce statements that are in the public interest, and the auditor is the agent
who should ensure GAAP is properly applied. An auditor who does not protect
the public interest can face reputational and legal consequences because the
expectations of the public have not been met.
5. Why didn’t the Arthur Andersen partners responsible for quality control stop the flawed
decisions of the audit partners?
They tried via memos, but the firm’s governance structure had earlier determined that the audit
partner in charge could over-ride them. Clearly, AA’s governing body made the
wrong decision.
6. Should all of Arthur Andersen have suffered for the actions or inactions of under 100 people?
Which of Arthur Andersen’s personnel should have been prosecuted?
I don’t think so, because it seems unfair to the many innocent partners, staff and audit
client stakeholders that lost value because of the resulting discontinuity. I further do not
believe that society was well-served by the loss of one of the Big 5, thus concentrating
the choices for independent audit work in the future. On the other hand, the
disappearance of AA sent a significant signal to the rest of the audit world. I would have
preferred larger fine and imprisonment for AA’s decision makers who determined and
carried out the policy of audit partner primacy, plus a very large fine and sanctions (no
new SEC clients for 3 months) for the continuing firm. I would also consider carefully
whether non-partner audit personnel had a responsibility for whistle-blowing, and would
signal how this should be done in the future.
7. Under what circumstances should audit firms shred or destroy audit working papers?
Given the developments in the AA Case, audit working papers should not be destroyed before
they could be of assistance and/or relevant in any legal, tax or other dispute. This
means that the auditor should retain paper or digital versions for a very long time.
Business & Professional Ethics for Directors, Executives & Accountants, 5e,
L.J. Brooks & P. Dunn, Cengage Learning, 2010
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In some jurisdiction, the statute of limitations might come into play at the end of
seven or ten years, but may not where fraud is concerned. An audit firm may
chose not to follow the statutory limits because they might wish to be able to
respond to protect themselves for a longer period. Public expectations that affect
reputations are not bound by legal limits.
8. Answer the “Lingering Questions” in the case,
See the answer to Question 6 above. I do not think that the Big 4 firms could be shrunk to the
Big 3 in the future because it would not be seen to be in the public interest. I
think that other AA partners will be brought to trial, but not many. Perhaps only
the head of the firm, the lawyer involved and the partners-in-charge of the firm
and the region or function will be brought before the courts. Finally, I am sure
that a similar tragedy will occur again – probably after the pain of ignoring the
public interest abates again as is has from earlier scandals in earlier decades. Our
memory fades as generations retire, and unless the education system plays a
stronger role with students in the future, ethics lessons will be forgotten again.
Subsequent events
July 15, 2003. “Andersen Worldwide settles Enron Suits”, Jef Feeley, Financial Post, July 15,
2003, FP9.
“The network of foreign accounting firms once linked to Arthur Andersen LLP
will pay US$40-million to resolves lawsuits stemming from Enron Corp.’s
collapse…
Andersen Worldwide Société Cooperative is seeking to erase liability in suits
filed by Enron investors and workers over the accounting firm’s role in helping
Enron hide more thanUS$1-billion in losses… The accord doesn’t cover Arthur
Andersen LLP, Enron’s auditor for more than a decade… Andersen Worldwide
also agreed to pay US$20-miooion to Enron’s bankruptcy creditors.
The settlement is a small fraction of the US$29-billion that shareholders and
former workers say they lost in Enron’s meltdown.”
May 31, 2005.
In the case of Arthur Andersen, LLP v. United States, 544 U.S. 696 (2005), the Supreme
Court of the United States unanimously reversed AA’s conviction due to serious flaws in
the jury instructions.
As of 2008, there were over 100 civil lawsuits pending against AA.
See also
Time Enron Scandal webpage at http://www.time.com/time/2002/enron/
http://en.wikipedia.org/wiki/Arthur_Andersen
Business & Professional Ethics for Directors, Executives & Accountants, 5e,
L.J. Brooks & P. Dunn, Cengage Learning, 2010
Instructor’s Manual, Chapter 2
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WORLDCOM: THE FINAL CATALYST
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What this case has to offer
When WorldCom announced massive overstatements of profit in June 2002, it completely
shattered the trust in corporate accountability and governance that President Bush and others had
been trying to rebuild. Sarbanes and Oxley combined their separate efforts in the U.S. Congress
and Senate, and the Sarbanes-Oxley Act emerged in late July 2002, thus triggering a change in
corporate accountability and governance, and well as the accounting profession. The WorldCom
case involves simple manipulations, but once again offers lessons about the need for an ethical
corporate culture, whistle-blower protection, over-dominant CEO, no independent Chair of the
Board, and incompetence of Directors. The prosecution and dissolution of AA was so far along
by June/July 2002, that their role in not finding the problems earlier was overshadowed by the
emergence of SOX.
Teaching suggestions
I review the events after Enron and up to SOX, and I indicate how it galvanized the development
of SOX. I then deal with the questions listed below.
Discussion of ethical issues
The following questions wee presented for discussion of the significant issues raised in the case:
1. Describe the mechanisms that WorldCom’s management used to transfer profit from
other time periods to inflate the current period.
Details are in the case, but the major mechanisms use included:
 Capitalization of current costs to move them to future periods
 Reduction of current costs by drawing down reserves
2. Why did Arthur Andersen go along with each of these mechanisms?
AA may not have known about the manipulations, or at least some of them. Cynthia Cooper,
Vice-president for Internal Audit was apparently the first to identify the
irregularities. According to the SEC quotations in the case, WorldCom went to
some lengths to conceal the manipulations from AA. However, this raises the
question of how effective AA’s audit work was because the manipulations were
significant. Moreover, if AA knew of some of the manipulations, then is it
another case of AA wishing not to confront management and preferring to protect
future fee revenue.
3. How should WorldCom’s Board of Directors have prevented the manipulations that
management used?
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An ethical corporate culture should have been developed that would have encouraged the
personnel who were ordered to manipulate to whistle-blow. If scrutiny and
analysis by internal and external auditors were known to have been tighter, then
perhaps the manipulation attempts would not have been attempted. Moreover, if
WorldCom had not been so dominated by Bernard Ebbers (i.e. if an independent
Chair of the Board and appropriate whistle-blowing mechanisms had been in
place) then he might not have tried to manipulate, and/or other might have
reported the attempt. Ebbers might not have attempted the manipulation if the
Board had not allowed him to borrow $408 million and spend it in ways that
required rising WorldCom stock prices and/or cash.
4. Bernie Ebbers was not an accountant, so he needed the cooperation of accountants to
make his manipulations work. Why did WorldCom’s accountants go along?
Because they thought they could get away with it for a while, and that when profits returned that
“adjustments” would be restored. They might have thought that everyone was
manipulating and that smoothed earning were ‘good”. They did not see their duty
as protecting the shareholders’ interests or the public interest.
5. Why would a Board of Directors approve giving its Chair and CEO loans of over $408
million?
The Board did not recognize the risk that Ebbers would misuse the funds borrowed. To some
extent the Board was at fault for allowing a loan arrangement for Ebbers where he
could draw down amounts on his own without reporting mechanism to the Board
and for subsequent approval as amounts rose beyond reasonable levels, and they
did not check on the specific use of the money and the vale of that usage as
collateral.. They trusted Ebbers who had built the company up from its early
roots. They did allow him to borrow money for the purpose of buying the largest
ranch in Canada, which was also unusual.
6. How can a Board ensure that whistleblowers will come forward to tell them about
questionable activities?
A protected whistle-blower mechanism is vital, and it’s use must be encouraged by top
management. Even then, there is no guaranty. In the end, an ethical corporate
culture is essential to the promotion of whistle blowing and ethical behavior in
general. This topic is discussed further in Chapter 3.
Business & Professional Ethics for Directors, Executives & Accountants, 5e,
L.J. Brooks & P. Dunn, Cengage Learning, 2010
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WASTE MANAGEMENT, INC.
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What this case has to offer
The Sunbeam and Waste Management cases were early, high profile evidence of Arthur
Andersen’s flawed decision making process, and approach to dealing with clients and “working
out” of audit adjustments rather than forcing large negative changes to financial statements or
qualifying their audit report. Both cases proved to damage AA’s reputation, and were
instrumental in generating sanctions from the SEC as well as triggering the SEC’s “take out”
response when AA failed a third time with Enron to rectify the same audit and decision making
deficiencies. In effect, the SEC was fed up with AA and decided to suspend the firm’s ability to
give opinions on SEC registrant clients rather than apply a monetary sanction that could readily
be paid and require another undertaking that could be ignored by AA.
Teaching suggestions
I ask a student in the class be asked to recap the main issues of the case, and then ask his/her
colleagues to add their comments. I make sure that the class understands the manipulation
methods revealed in the case, and the motivation for them. I would then discuss the questions
listed at the end of the case and answered below
Discussion of ethical issues
1. Why didn’t Arthur Andersen stand up to WMI management?
Arthur Andersen didn’t stand up to the management of Waste Management, Inc. (WMI)
because the firm wanted not to aggravate the management (Buntrock et al) an raise the
risk of losing a lucrative audit and consulting client. The penalty for not demanding
immediate corrections or an audit opinion qualification was quite low at the time relative
to the revenue being generated, and the risk that WMI would not make a profit must have
seemed low. A long-term work out of errors (slow correction over future years) may
have seemed to be reasonable solution at the time. Of course, the overall financial
picture changed, and AA was caught.
2. What aspects of their risk management model did the Arthur Andersen partners incorrectly
consider?
AA’s partners failed to accurately consider the cumulative damage to AA’s reputation,
particularly with the SEC. As mentioned in the opening comment on this case, the SEC
ultimately became fed up and AA lost its franchise to operate. Ultimately AA did not
correctly compute its franchise risk and the cumulative change therein.
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3. To whom should Arthur Andersen have complained if WMI management was acting
improperly?
To the WMI Audit Committee and Board, particularly to the independent directors
4. Did the WMI Board and Audit Committee do their jobs?
I would say that the WMI Board and Audit Committee did not do their jobs as fiduciaries
of the public interest, and particularly they did not protect the interests of some
shareholders who acquired shares under false pretenses as well as others like banks and
governments.
5. Were the fines levied high enough?
With hindsight, I would say that the fines were not high enough to change AA’s behavior
or signal other executives that this kind of manipulation should stop.
6. Should you use the same “dog” to discover the “bones” in an accounting scandal?
Using an agent that has made mistakes, does not guaranty the mistakes will be rectified or
that the “dog” will offer the best service available. The statement is ridiculous. AA was
probably retained so that they would not embarrass management or perhaps the major
shareholder, Mr. Buntrock.
Business & Professional Ethics for Directors, Executives & Accountants, 5e,
L.J. Brooks & P. Dunn, Cengage Learning, 2010
Instructor’s Manual, Chapter 2
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SUNBEAM CORPORATION AND CHAINSAW AL
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What this case has to offer
The Sunbeam and Waste Management cases were early, high profile evidence of Arthur
Andersen’s flawed decision making process, and approach to dealing with clients and “working
out” of audit adjustments rather than forcing large negative changes to financial statements or
qualifying their audit report. Both cases proved to damage AA’s reputation, and were
instrumental in generating sanctions from the SEC as well as triggering the SEC’s “take out”
response when AA failed a third time with Enron to rectify the same audit and decision making
deficiencies. In effect, the SEC was fed up with AA and decided to suspend the firm’s ability to
give opinions on SEC registrant clients rather than apply a monetary sanction that could readily
be paid and require another undertaking that could be ignored by AA.
Teaching suggestions
I would suggest that a student in the class be asked to recap the case, and then ask his/her
colleagues to add their comments. I would want to ask whether the class thought that Chainsaw
Al’s overbearing style represented a common or uncommon stereotype. This discussion usually
reveals that his dominating approach is not common, but by no means unique. It is a common
thread through most of the AA cases discussed in Chapter 2. I would then discuss the questions
listed at the end of the case and answered below.
Discussion of ethical issues
1. Explain how Chainsaw Al used “cookie jar” reserves to inflate Sunbeam’s profit?
In principle, “cookie jar” reserves are created when an opportunity presents (i.e. to
overstate costs of reorganization) itself to overstate expenses in one reporting period and
carry forward the credit as a “reserve” to be used to understate future expenses. This
shifts profit forward to the future period when management decides extra profit is needed
(i.e. the cookies are needed).
2. Can “bill and hold” practices ever be considered sales that should be recorded in the period in
which the goods are initially “held”?
Not unless there is an explicit (written) agreement that the goods are being held at the
request of the customer who accepts the risks of storage at the seller’s premises without
condition. This means that the seller cannot take the goods back for a credit. Also, the
buyer should pay for the goods.
3. Why didn’t Sunbeam’s Board of Directors catch on to the manipulations?
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The Board was not informed until one of the internal auditors, Deidra DenDanto,
resigned because no one would listen on April 3, 1998, and sent a letter to the Board. A
stock analyst, Andrew Shore, had raised the alarm earlier but the Board was apparently
not on guard. The unethical culture that Chainsaw Al and his associate, Russell Kersh,
had created made sure that earlier concerns did not reach the Board. A culture of loyalty
and silence was created by a system of stock options to 250 of the company’s top 300
executives.
4. How should a Board make sure that it gets the information it needs to monitor management
actions and accounting policies?
The Board should have introduced a whistle-blowing mechanism with reports to it at an
earlier date, and should have been aware of the culture that was being created within the
company as well as the style of management being practiced. They should make the
opportunity to make contact with and get to know executives so these executives will
contact them if need be, and to assess their competency when projects are being
evaluated. Surveys of personnel attitudes can also be taken by outside services.
5. If you are a professional accountant who reports an ethical problem to your superior who
does nothing, what more should you do?
I would continue to report ‘up the line’ until I got reasonable answer, or to the
ombudsman or ethics officer, or finally to the Audit Committee, or the Chair of the
Board.
6. What problems can you identify with Arthur Andersen’s work as auditor of Sunbeam?
The problems that could reflect poor audit work by AA might include:
 Failure to verify reasonability of reserves such as by estimates of restructuring
charges after the restructuring, and the ultimate use of the “cookie jar” credits thus
created,
 Failure to detect channel stuffing through normal cutoff tests, reviews of inventory
amounts, unusual sales and discount practices
 Failure to review large or unusual inventory and sales transactions, and large changes
in reserves
 Poor cutoff tests that did not detect the extension of a reporting period.
 See also the section on AA’s Role
7. How should a Board assess the performance of their company’s auditors?
A Board can assess the performance of the company’s auditors by:
 Questioning them on their audit approach, findings and discussions with management
 Assessing them on their knowledge of the company and its industry by posing
questions about alternatives likely to be under consideration
 Assuring that auditors understand that they are to report specific problems to the
Board and are independent of management influence
 Discuss the external auditors’ performance with management and separately with the
head of internal audit.
 Compare the auditor’s performance with that of other auditors that board members
Business & Professional Ethics for Directors, Executives & Accountants, 5e,
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
have encountered
Periodically ask for bids from other firms and the incumbent auditors
8. While it is attractive to have a CEO that is a strong person with a high profile, how should a
board manage or keep track of such a person without demotivating them?
CEOs must be expected to report regularly to the Board on standard matters and for any
significant matters, particularly those requiring policy advice. The Board has a right to
be kept up to date, to consult other executives, make policy recommendations and operate
their portion of the governance system. Boards should not be a rubber stamp. They
should set or approve strategy and policy, provide advice, evaluate performance and
ensure compliance with policy and the law. If a Board member believes that s/he is not
getting enough information, s/he should raise the matter and should consider resignation
if the matter is not resolved. The Board also should have the right to meet without
management present. See further discussions in Chapters 2 and 3.
9. Can a Board effectively monitor a CEO who is also the Chair of the Board?
Not unless there is a “Lead Director” who acts as a quasi-chair and runs that portion of
every Board meeting wherein the CEO and Chair is invited to leave the room for open
discussion by the rest of the Board, or when matters pertaining to the CEO and Chair are
being discussed.
Business & Professional Ethics for Directors, Executives & Accountants, 5e,
L.J. Brooks & P. Dunn, Cengage Learning, 2010
Instructor’s Manual, Chapter 2
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Multiple Choice Questions
_______________________
1) Most observers agree that Enron’s problems were caused by:
a.
b.
c.
d.
e.
Management’s failure to exercise adequate oversight
Failure of the audit committee to exercise adequate oversight
Auditor’s lack of independence
Deficiencies in audit procedures
Failure of the board of directors to exercise adequate oversight
ANSWER: e
2) Under the U.S. accounting rules, the following conditions were required to consider special purpose
entities (SPEs) to be independent parties:
a. Independent investment of less than 3% of the SPE’s equity and independent control of the
SPE
b. Independent investment of at least 3% of the SPE’s equity and independent control of the
SPE
c. Substantive investment of at least 3% of the SPE’s equity and independent control of the SPE
d. Independent investment of at least 3% of the SPE’s assets at risk and independent control of
the SPE
e. Substantive investment of less than 3% of the SPE’s assets at risk and independent control of
the SPE
ANSWER: d
3) The Board of Directors’ paramount duty is:
a.
b.
c.
d.
e.
To determine management’s compensation
To safeguard the interest of the company’s stakeholders
To safeguard the company’s assets
To formulate the company’s strategy
To safeguard the interest of the company’s shareholders
ANSWER: e
4) The independence of the Enron Board of Directors was compromised by:
a.
b.
c.
d.
e.
Family ties between the company and certain board members
Employment ties between the company and certain board members
Financial ties between the company and certain board members
Fiduciary ties between the company and certain board members
All of the above
ANSWER: c
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5) The following three broad duties stem from the fiduciary status of corporate directors:
a.
b.
c.
d.
e.
Obedience, loyalty, and confidentiality
Obedience, loyalty, and due care
Loyalty, due care, and confidentiality
Obedience, loyalty, and good faith
Loyalty, confidentiality, and good faith
ANSWER: b
6) In order to ensure an investment-grade credit rating, Enron began to emphasize the following three
actions:
a.
b.
c.
d.
e.
Reducing accruals, increasing cash flow, and lowering debt
Smoothing accruals, increasing cash flow, and lowering debt
Increasing cash flow, lowering debt, and smoothing earnings
Increasing cash flow, lowering earnings and decreasing option expense
Increasing cash flow, lowering debt, and decreasing option expense
ANSWER: c
7) Which of the following was not a committee in Enron’s Board?
a.
b.
c.
d.
e.
Risk Management Committee
Executive Committee
Finance Committee
Audit and Compliance Committee
Nominating Committee
ANSWER: a
8) Enron referred to this transactions as “monetizing” or “syndicating” its assets:
a.
b.
c.
d.
e.
Buy more assets using syndicated loans
Sell assets to third parties and record cash income as earnings
Hedge the company’s assets
Lend money to third parties to buy assets
Recording profits on energy derivatives trading
ANSWER: b
9) Enron created the following SPE(s) to hide off-balance sheet liabilities, recognize revenues early ,
and recognize profits on own shares:
a.
b.
c.
d.
LJM
LJM1/Rhythms
LJM2/Raptors
Chewco/JEDI
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e. LJM3
ANSWER: d
10) Which of the following was not a flaw found in LJM1 arrangements?
a.
b.
c.
d.
e.
Profits were improperly recorded on treasury shares used or sheltered by non-existing hedges
Enron was hiding employee stock option expense
Enron was hedging itself
Enron had to advance treasury shares to buy them back at preferential rates
Enron officers and their helpers benefited
ANSWER: b
11) At the time of Enron’s collapse, the prevailing treatment for employee stock option expense was:
a.
b.
c.
d.
e.
Record stock options only when and if exercised, at exercise price
Record all stock options when issued, at exercise price
Record all stock options at market price
Record stock options only when exercised at market price
Record not exercised options at market price
ANSWER: a
12) Which of the following was not a conflict of interest that Arthur Andersen’s personnel encountered?
a.
b.
c.
d.
Auditing their own work as SPE consultants
Losing a very large client
A partner reviewed another partner’s work
Internal debates about Enron’s questionable accounting treatments were not discussed with
the audit committee
e. Audit staff leaving the firm to work for Enron
ANSWER: c
13) Which of the following was not among Arthur Andersen’s shortcomings in conducting Enron’s
audit?
a.
b.
c.
d.
e.
Lack of competence
Failure of quality control standards
Misunderstanding of auditor’s fiduciary role
Inconclusive testing of control
Insufficient information provided by Enron’s staff
ANSWER: d
14) Which of the following was not a strategy used by Enron to avoid taxes?
a. Deduction of losses twice
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b.
c.
d.
e.
Shifting depreciable assets to non-depreciable assets
Tax deductions for repayment of debt principal
Duplication of single economic loss
Generation of fees for serving as an accommodation party for another taxpayer
ANSWER: b
15) In general terms, WorldCom overstated its reported net income by:
a.
b.
c.
d.
e.
Generating false expenses
Booking false revenue
Capitalizing line costs
Amortizing line costs quicker than allowed under GAAP
Recognizing future period’s revenue
ANSWER: c
16) This type of manipulation is known as “cookie jar” accounting:
a.
b.
c.
d.
e.
Manipulation of profits through reserves or provisions
Incorrect classification of long term debt as equity
Incorrect classification of regular expenses as extraordinary items
Manipulation of profits through booking revenue in early periods
Manipulation of reserve for uncollectible amounts
ANSWER: a
17) After SOX, which of the following is not a prohibited non-audit service for external auditors?
a.
b.
c.
d.
e.
Appraisal or valuation services
Bookkeeping and other services
Legal services
Tax services
Internal audit outsourcing
ANSWER: d
18) Which of the following is not a requirement imposed by the SOX Corporate Governance
Framework?
a. The audit committee must be comprised solely by independent directors
b. The audit committee is responsible for appointing the company’s external auditor
c. The audit committee must establish procedures to allow employees to submit anonymous
complaints
d. The audit committee must approve non audit services to be provided by the auditors
e. The audit committee must be comprised solely by financial experts
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ANSWER: e
19) SOX increased the time requirement and legal risk for company directors. These requirements will
likely:
a.
b.
c.
d.
e.
Increase the number of directors in the board
Reduce the number of directors in the audit committee
Increase audit fees
Reduce the number of boards that each director sits on
All of the above
ANSWER: d
20) These companies are more likely to voluntarily adopt improved governance measures:
a.
b.
c.
d.
e.
Larger companies
Less profitable companies
Foreign companies
Smaller companies
Private companies
ANSWER: a
Business & Professional Ethics for Directors, Executives & Accountants, 5e,
L.J. Brooks & P. Dunn, Cengage Learning, 2010