Enron: Accounting expertise
to the rescue
Steve Salterio Ph.D. CA
Associate Professor of Assurance
School of Accountancy
with the assistance of the following students:
Jill Considine
Alan Jin
Amy Kane
Matt Martorello
The Story Line






What was Enron?
Why did Enron come to prominence?
What happened at Enron?
What were the accounting warning signs?
What does accounting research say about
why they were ignored?
What are the organizational impediments to
leveraging expertise?
Brief History of Enron

1985 - Houston Natural Gas merges with
InterNorth, a natural gas company based in
Omaha, Neb., to form an interstate and intrastate
gas pipeline company with 37,000 miles of pipe.

1986 - Kenneth Lay is appointed
chairman and chief executive officer.

1989 - Over the years, the company becomes
the largest natural gas merchant in North America
and the United Kingdom
Brief History of Enron

Aug. 2000 - Shares hit an all-time high of
$90.56

Dec. 2000 – Enron announces Jeffrey
Skilling (President) will take over as CEO.

Aug. 14, 2001 - Skilling resigns; the
company attributed his departure to “personal
reasons”.
Brief History of Enron

Aug. 22, 2001 Sherron Watkins, a
vice president, writes
to CEO Lay, warning
him that the company
might "implode in a
wave of accounting
scandals."
Brief History of Enron

Oct. 12, 2001 David Duncan, Andersen’s audit
partner in charge of Enron, says Andersen's lawyers
had suddenly began emphasizing Andersen's policy
allowing destruction of “unneeded” documents.

Duncan organizes a two-week document destruction
effort to discard many records.

Oct. 16, 2001 - Enron reports its first quarterly loss
in over four years after taking charges of $1 billion on
“poorly performing businesses”.
Where did the billion go?
The Raptors partnerships


Enron gave a related party called “Raptor”
3.7 million shares of Enron common stock
Enron received $1.2 billion in notes
receivables



IOU’s from a company Enron owned
Enron called this income!
Andersen’s Duncan accepts this accounting
in 2000 and 2001 over the objections of
Andersen’s technical accounting partners
Cash
Asset
3%
Cash
Guarantee
Cash
Asset
Guarantee
< 3%
Cash
Transactions
Source: WSJ, 1/21/02
Then what happened?






12-2-01 – Enron files Ch. 11 bankruptcy
01-09-02 -- Justice Department opens a criminal
investigation
01-10-02 – Andersen admits Houston office
shredded documents
01-17-02 – Enron fires Andersen
01-25-02 -- Enron Vice Chairman commits suicide
02-02 David Duncan, Andersen auditor in charge of
Enron audit, is charged with obstruction of justice
Then what happened?



03-02 Andersen firm is charged with obstruction of
justice
04-02 David Duncan plea bargains for a reduced
sentence in return for implicating the entire
Andersen firm in the obstruction of justice charge
06-02 Andersen is found guilty of obstruction of
justice and ends the 89 year practice of auditing.
Dispelling Accounting Myths
1. Auditors create financial statements.
WRONG
2. There is a comprehensive accounting rule book –
you just have to look up the right answer.
WRONG
3. There is no judgment in accounting.
WRONG
4. The auditor is a independent third party.
IT DEPENDS HOW YOU LOOK AT IT
How do auditor’s deal with
difficult accounting issues?


By definition, you can’t look up a rule
Consult





others on the audit team
others in your office
others auditing in the same industry in other offices
All this consultation is mediated by computer data
bases, electronic mail and expert systems that
collect data “just in case”
Finally consult national office technical “gurus”
Accounting research: Based on
Naturalistic Decision Making Theory


Situation assessment stage
Searching data bases for prior similar cases
where the facts are roughly the same to
current case




External data bases
Firm specific data bases
Can be considered an information search task
Two units:


Central Research Unit (Salterio 1994, 1996)
Accounting Consultation Unit (Salterio and
Denham 1997)
Accounting Expertise
Measures: CRU’s


Examine managers who interface with
computer system to advise audit partners
about appropriate accounting policies.
Effectiveness measures (Table 2, Salterio
1996) over six month “tour of duty” managers



Increase number of “on point” findings from 4.26
per case to 7.63 per case (66% increase)
Review time (e.g. quality control) decreases 0.93
to 0.68 (33% decrease)
Number of reviewer enquiries decreases
Accounting Expertise
Measures: CRUs

Efficiency measures (Table 3)

Time employed by managers to



Search strategy of managers


Search computer data bases on line decreased by 2.5
minutes
Total time to perform research reduced by .7 hour
More complex search using more Boolean operators
per search
Number of potential precedents examined


Total number of precedents increase 12.5
Average number of precedents increase 3.3
CRU Research conclusions


Salterio (1996) shows that in searching for
“precedents” used by local offices there is a
significant expertise effect for those located in
the Central Research Unit for six months
Think about the amount of expertise gained
through years of national office residency
that partners in the Accounting Consultation
Unit gain
Accounting Consultation Units



Salterio (1994, 1996) done in US
Salterio and Denham (1997) done in Canada
but strong analogy can be made to US
setting (and most of the research was
repeated in US environment)
Was not allowed to study Andersen, the only
member of the then “Big 6” firms to refuse to
participate
Organization Memory Theory


OM is composed of the individual memories
of firm members plus the firm’s standard
operating procedures (SOP’s), organizational
structure and organizational culture as well
as any internal and /or external archives
(data bases)
SOP’s are embedded both in human routines
as well as computer systems
OM Theory:
Discovering organizations

2 Canadian firms (and all US firms studied) are
classified as discovering organizations:

Ability to scan the environment


Customer focus


Audit office client is focus hence understanding
business reason for issue is key
Search processes employed


Resources – both people and data high
Informal and formal searches made utilizing all
resources available
Goal to come up with “best” answer that
complies with GAAP
OM Theory:
Discovering organizations

Firm wide peer review looks for:



Consultations that should have been made even if
not mandatory by firm policy.
Consistency across clients was “gold standard”
Emphasis on early consultation
Standard operating policies



An objection by the ACU partner to the
accounting desired by the local office partner
(and called for by the client management)
must be reported on and judged by the senior
managers of the audit firm.
Almost never was an ACU position overruled.
Remember, the only Big 6 firm I was unable
to get assess to was Andersen (see 3rd page
(674) of Salterio and Denham (1997)).
Andersen’s Professional
Standards Group

Until roughly 1990 Andersen had followed
similar practices to other Big 6 firms




A very strong and powerful national office
technical group
If anything, they were the most conservative
auditors of all of the Big 6
In early 1990’s Andersen changed its policy to
help local office partners obtain new business
Indeed it was a “selling point” at Andersen
Andersen’s Professional
Standards Group Objects to Enron

1999 Carl Bass repeatedly objects to early
Enron accounting for the various partners
(i.e. the Raptors)



his objections continued in 2000
His continual objections caused Duncan (at
the behest of Enron) to ask Andersen’s
national office to remove Bass.
National office accepted his request and
transferred Bass.
Andersen’s SOP Limits
Professional Standards Group



Unlike the other firms, the local office partner
(i.e. Duncan) could overrule the technical
partner (i.e. Bass) by reference to the
practice director in his own office.
Overruling does not have to be referred to
Andersen’s CEO and executives as in other
audit firms.
Business Week highlighted this practice
difference in its coverage of Enron in early
2002
If Andersen had followed
others’ SOPs?




Senior Andersen managers would have been
in the decision making loop in 1999.
Rarely do senior audit firm managers
overrule technical partners in other firms.
Enron’s initial rogue accounting could have
been stopped in 1999!!!!
Lack of expertise was not the reason
Andersen failed in its audit responsibility!!!!
Could Andersen have
prevented Enron’s implosion?



Maybe not, but the accounting might not have
been used to prolong the life of Enron.
Enron might have had difficulty surviving if
the correct accounting had been done in
1999.
Early discovery could have prevented many
of the transactions that were entered into in
2000 and 2001 that caused the vast majority
of the losses.
Academic research to the
rescue???



Well maybe not, . . . . . But, what if I had been
able to get into Andersen in 1996-97?
Would they have listened to the finding that
they were an outlier among their peers?
Some interesting evidence:


In Canada, one of the conditioned learning firms
moved to the discovery mode after my research
was made public.
The mixed firm has also moved strongly to a
discovery mode.
Leveraging expertise

Andersen had:



state of the art computer technology, computer
systems and people to operate and develop the
technology
cutting edge technology which it applied to both
manage the individual audit and to manage the
firm as a whole.
some of the best minds in accounting industry
were located in their Professional Standards
Group and were supported with state of the art
technological and systems resources
Leveraging expertise


but the firm’s organizational memory was set up in
such a fashion that the experts and their support
systems were used to support marketing the firm
instead of ensuring the highest quality accounting
experts, expert systems and technology without
assess to managerial power to prevail can result
in the same decisions that would be made in the
absence of such expertise.