Sandra K. Knutson
Acct 460 Audit 1
Research Paper
Enron Corporation: What Happened
Enron engaged in questionable accounting practices that ultimately led to the demise of
the 7th largest firm by market capitalization in a relatively short time frame. Arthur Andersen’s
audit procedures did not reflect the risk associated with these transactions, due to a reluctance to
lose rather large management fees, resulting in their demise as well. (Edelman & Nicholson,
2010, p. 3) Key Enron employees were prosecuted for fraud, conspiracy and eventually found
guilty. Arthur Andersen, LLP ceased to exist as a “Big Five” accounting firm and auditors
involved in the Enron audits were disciplined by Texas State Board of Public Accountancy and
the Securities and Exchange Commission. The scandal caused resulting legislation known as the
Sarbanes-Oxley (SOX) Act, in an effort to prevent an event like this happening again as well as
to restore public confidence. The actions of management at Enron and the Arthur Anderson
auditors assigned to audit Enron have had far reaching effects on corporate America and the
public accounting profession.
Enron was formed in 1985 when two pipeline companies, Houston Natural Gas and
InterNorth, Inc. out of Nebraska merged. Kenneth L. Lay was chairman and chief executive
officer of Houston Natural Gas and after the merger, was named chairman and chief executive
officer of Enron in 1986. Immediately, Enron began to expand beyond pipelines and the
transportation of natural gas. Jeffrey Skilling, a senior partner at McKinsey & Co. Consulting,
and who later became Enron’s president and chief operating officer, set Enron up to trade in
natural gas futures. Buying up natural gas from producers and selling it to consumers for a
contracted price. Because of their success with natural gas, Enron lobbied Congress to deregulate
the sale of electricity allowing Enron to expand into electricity trading operations in the United
States. They soon dominated the market. “Enron traded in futures contracts for coal, paper, steel,
water and even offered weather derivatives with which utilities could insure their profits against,
say, an unusually mild winter” (Stice & Stice, 2006, p. 87). Enron On Line (EOL) launched in
October, 1999, an online trading Web site and it became a huge success. Enron also looked at
trading broadband Internet access. “Enron’s stock hit $90.56 in August of 2000 and the company
was being touted by Fortune and other publications as one of the most admired and innovative
companies in the world” (Thomas, 2002, p. 42).
Arthur Andersen, LLP, was part of the group of accounting firms known as “the Big
Five” and was formed in 1913 when Mr. Andersen went into partnership with Charles Delaney
creating Andersen, Delaney, & Co. In 1918, the firm split and became Arthur Andersen & Co.
Mr. Andersen wanted his firm to be “more than just another accounting firm, but to be honest
and to think straight and talk straight” (Edelman & Nicholson, 2010, p. 2). Andersen started his
firm by including a management-information consulting practice, and by 1979, it had become the
world’s largest professional services firm. In 1989, the accounting and consulting portions of
Arthur Andersen had split into two separate entities. (Brown & Dugan, 2002) Arthur Andersen
was involved in several lawsuits over accounting scandals and bankruptcies including Waste
Management, Sunbeam, Boston Market and Baptist Foundation of Arizona prior to the Enron
trial for obstruction of justice. (Brown & Dugan, 2002)
With the hiring of Andrew Fastow, manager of Enron Finance Corporation, Enron
created thousands of Special Purpose Entities (SPEs) in an effort to shift liabilities off their
books. Some of these SPE’s did not meet the 3% minimum control test to set up SPE’s. “Enron
abused the accounting rules for SPE’s in two ways. First a number of the SPE’s established by
Enron were not independent from the company at all..Second, it is clear from the transactions
between Enron and some of these SPE’s that the sole reason for their existence was to allow
Enron to engage in transactions to which no independent company would have ever agreed”
(Stice & Stice, 2006, pp. 89-90). This allowed them to recognize profits while minimizing debt.
After his interview with “Frontline” PBS, Jeffrey Skilling was asked what his top priority was,
stating: “his answer came lightening fast: to get the stock price up.” (Eichenwald & Henriques,
2002, p. 3)
Enron also utilized the mark-to-market accounting method to value their energy related
derivatives. This required adjusting them to fair market value at the end of a quarter. C. William
Thomas, CPA, PhD, notes “A difficulty with application of these rules in accounting for longterm futures contracts in commodities such as gas is that there are often no quoted prices upon
which to base valuations. Companies having these types of derivative instruments are free to
develop and use discretionary valuation models based on their own assumptions and methods”
(Thomas, 2002, p. 43).With Enron’s corporate culture of maximizing earnings these valuations
may have been somewhat overstated. Many of the SPE’s had arrangements where they were
financed by Enron stock. “If Enron’s own credit rating fell, Enron faced a variety of
consequences, all of them damaging to its reported profits” (Eichenwald & Henriques, 2002, p.
3). “Enron executives apparently used SPEs to deceive shareholders and enrich themselves, by
structuring transactions to hide many liabilities and commitments, while reaping massive
personal gains. Such Enron transactions do not appear to have been made at arm’s length,
although its (detailed) footnotes stated otherwise” (Reinstein & McMillan, 2004, p. 963). Once
the price of Enron’s shares of stock started falling this entire system of accounting began to
unravel forcing Enron to re-state its income back to 1997.
The beginning of the end appeared in August of 2001 when Sherron Watkins, an
employee under Andrew Fastow, wrote an anonymous letter to Lay. “Watkins soon came
forward and met with Lay regarding her concerns and he promised to have the firms lawyers
look into it. Ms. Watson also contacted an acquaintance at Andersen for advice. The friend
drafted a memo detailing her concerns for the Enron auditors” (Duffy, 2002). Sometime in
September, 2001, auditors at Andersen discovered an error made over a year earlier in the way
Enron shares used to finance the Raptor partnership had been recorded. This announcement by
Enron got the attention of the SEC. At this point the decision was made to dissolve the Raptor
group rather than issue Enron stock to offset the entities losses. This required Enron to restate
their third quarter earnings for 2001, reducing its after-tax income. “On November 8, 2001,
Enron announced a restatement of its financial statements back to 1997 to reflect consolidation
of the SPE’s it had omitted, as well as to book Andersen’s recommended adjustments for those
years, which the company had previously deemed immaterial” (Thomas, 2002, p. 44). A
pending merger with Dynegy was called off. The markets reacted to these events by dropping
Enron stock to $.26. Enron filed for bankruptcy on December 2, 2001.
The names most closely identified with the Enron Scandal include Kenneth Lay, chief
executive and chairman; Jeffrey Skilling, chief executive and previously chief operating officer
and president; and Andrew Fastow, chief financial officer. Lay was indicted and found guilty of
10 counts of conspiracy and fraud May 25, 2006. Mr. Lay died of a heart attack while on
vacation in Colorado in July of 2006, he was never sentenced. A Federal Judge vacated Lay’s
conviction citing a 2004 ruling that found a defendant’s death pending appeal extinguished his
entire case. Skilling is serving a 24 year sentence for fraud and insider trading. He did appeal 19
of the 28 counts to the U.S. Supreme court asking them to consider if he had deprived his
company of intangible honest services. The U.S. Supreme Court found he had not violated the
honest services rule and passed down to the U.S. Court of Appeals for the Fifth Circuit whether
this should alter his conviction; they ruled it should not. Skilling is appealing this ruling. Fastow
faced a 10-year sentence but was given a six-year sentence as a result of his cooperation with
authorities. Other individuals involved with Enron include J. Clifford Baxter, chief strategy
officer, who committed suicide January 25, 2002, after being subpoenaed. Lou Pai, chief
executive of Enron Energy Services, resigned from Enron six months before they filed for
bankruptcy, cashing in nearly $300 million in Enron stock. The SEC alleged he sold the stock on
the basis of non-public information. Pai settled without confirming or denying the allegation.
Rick Causey, chief accounting officer, pled guilty to wire fraud and conspiracy charges and
agreed to testify against Lay and Skilling. He went to prison in January, 2007 and was released
in October, 2011. Sherron Watkins, vice-president of corporate development, now has her own
public speaking and consulting firm, Sherron Watkins & Company. (Partington, 2011)
Three of the auditors from Arthur Andersen involved in the Enron audit lost their CPA
license in the state of Texas, David Duncan, Thomas Bauer and Carl Bass. They were also
suspended from practicing or appearing as an accountant before the SEC. Thomas Bauer can
appeal after three years. Michael C. Odom retains a Louisiana CPA license and is also denied
appearance or practice before the SEC. Michael M. Lowther and Patricia Grutzmacher’s licenses
are currently suspended with the State of Texas. Andrew Schuleman received a public reprimand
and currently maintains his Texas license. James Brown Jr. and Jennifer Stevenson complaints
were dismissed. Derek Claybrook was charged with failure to properly complete or follow audit
procedure. (Edelman & Nicholson, 2010, pp. 3-5) Arthur Andersen was convicted of obstruction
of justice, a conviction that was later overturned but by then it was too late. “On August 31,
2002, Arthur Andersen closed its doors and watched its impressive array of audit clients switch
their business to other auditors” (Stice & Stice, 2006, p. 91).
The most wide reaching legislative reform since perhaps the Securities Acts of 1933 and
1934 was enacted as a result of this and other public corporate accounting scandals, the
Sarbanes-Oxley (SOX) Act of 2002. This act provided for a variety of accounting reforms
including tightening up on auditor independence, prohibiting auditors from providing
management services, issuing audit reports on management’s assessment of internal controls ,
enhanced financial controls for off-balance sheet transactions and special purpose entities and
reconciling to GAAP financial statements. The act also requires auditors to rotate off an
engagement with a client once they have performed audit services with that client for five years.
The act enacted substantial corporate governance reforms for audit committees too. It makes the
audit committee responsible for the oversight of the firm’s auditor - the auditor now reports
directly to the audit committee. Each member of the audit committee must be independent and
the audit committee is charged with having procedures in place for handling confidential
submission by employees of complaints, in other words having a “whistle-blower” policy.
CEO’s and CFO’s were made more accountable as well; they are now required to certify the
financial reports. The Public Company Accounting Oversight Board was established by SOX to
regulate accounting professionals who audit the financial statements of public companies. This
board is responsible for, among other things, establishing or adopting auditing, quality controls,
ethics, independence and other standards relating to the preparation of audit reports. SOX
implemented regulations in regard to document destruction and it significantly increased the
penalties for violations of securities law. All of the items contained in SOX were included in an
effort to restore confidence in financial markets, improve public disclosures of financial
information, and strengthen corporate governance. (Miller & Pashkoff, 2002)
Enron filed for bankruptcy on December 2, 2001. When Enron’s plan for recovery was
approved by the courts the board of directors changed Enron’s name to Enron Creditors
Recovery Corporation (ECRC). ECRC’s “sole mission is to reorganize and liquidate the
remaining operations and assets of Enron following one of the largest and most complex
bankruptcies in U.S. history.” (Enron Creditors Recovery Corp., 2012) It states on their website
the proceeds obtained will be distributed to the company’s creditors. Once all assets have been
liquidated and final distribution is made to creditors, the company will cease to exist. Arthur
Andersen LLP, the accounting firm ceased to exist August 31, 2002. Accenture Ltd, the
consulting firm that split from Arthur Andersen in 1989, is still in existence. Their web site states
they have 257,000 employees in 120 countries and generated 27.9 billion in revenues for the
fiscal year ended August 31, 2012 (About Accenture, 2012).
Perhaps the biggest tragedy in all of this is the tens of thousands of employees of both
Enron and Arthur Andersen who lost not just their employment, but in the case of Enron
employees, their retirement funds as well through the imprudent and greedy actions of a select
group of people motivated most assuredly by the lure of money and power.
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