Business Fraud

(The Enron Problem)

W. Steve Albrecht
Ph.D., CPA, CIA, CFE
Brigham Young University

© 2003, 2005 by the AICPA

This presentation is intended for use in higher education for instructional purposes only, and is not for
application in practice. Permission is granted to classroom instructors to photocopy this document for
classroom teaching purposes only. All other rights are reserved. Copyright © 2003, 2005 by the
American Institute of Certified Public Accountants, Inc., New York, New York.
 These Are Interesting Times
Number and size of financial statement frauds are
increasing
Number and size of frauds against organizations
are increasing
Some recent frauds include several people—as
many as 20 or 30 (seems to indicate moral decay)
Many investors have lost confidence in credibility
of financial statements and corporate reports
More interest in fraud than ever before—now a
course on many college campuses

© 2003, 2005 by the AICPA

 Example of a Fraud Where I Testified

Large Fraud of $2.6 3,000,000,000

Billion over 9 years 2,500,000,000
– Year 1 $600K
2,000,000,000
– Year 3 $4 million
1,500,000,000
– Year 5 $80 million
1,000,000,000
– Year 7 $600 million
500,000,000
– Year 9 $2.6 billion
0
In years 8 and 9, four of Year 1 Year 3 Year 5 Year 7 Year 9

the world’s largest banks

were involved and lost
over $500 million

© 2003, 2005 by the AICPA

 Why Fraud is a Costly Business
Problem
Fraud Losses Reduce Fraud Robs Income
Net Income $ for $
Revenues $100 100%
If Profit Margin is 10%,
Expenses 90 90%
Revenues Must Increase Net Income $ 10 10%
by 10 times Losses to Fraud 1
Remaining $ 9
Recover Affect on Net
Income To restore income to $10, need
– Losses……. $1 Million $10 more dollars of revenue to
generate $1 more dollar of
– Revenue….$1 Billion
income.

© 2003, 2005 by the AICPA

 Fraud Cost….Two Examples
General Motors Bank
– $436 Million Fraud – $100 Million Fraud
– Profit Margin = 10% – Profit Margin = 10 %
– $4.36 Billion in – $1 Billion in Revenues
Revenues Needed Needed
– At $20,000 per Car, – At $100 per year per
218,000 Cars Checking Account,
10 Million New
Accounts

© 2003, 2005 by the AICPA

 Financial Statement Fraud
Financial statement fraud causes a
decrease in market value of stock of
approximately 500 to 1,000 times the
amount of the fraud.

$7 million fraud $2 billion drop in

stock value

© 2003, 2005 by the AICPA

 Types of Fraud
Fraudulent Financial The common element
Statements is deceit or trickery!
Employee Fraud
Vendor Fraud
Customer Fraud
Investment Scams
Bankruptcy Frauds
Miscellaneous Frauds

© 2003, 2005 by the AICPA

 Recent Financial Statement
Frauds
Enron
WorldCom
Adelphia
Global Crossing
Xerox
Qwest
Many others (Cendant, Lincoln Savings, ESM,
Anicom, Waste Management, Sunbeam, etc.)

© 2003, 2005 by the AICPA

 Current Executive Fraud-Related
Problems
Misstating Financial Statements: Quest, Enron,
Global Crossing, WorldCom, etc.
Executive Loans and Corporate Looting: John
Rigas (Adelphia), Dennis Kozlowski (Tyco--$170
million)
Insider Trading: Martha Stewart, etc.
IPO Favoritism: John Ebbers ($11 million)
CEO Retirement Perks: Delta, PepsiCo, AOL Time
Warner, Ford, Fleet Boston Financial, IBM
(Consulting Contracts, Use of Corporate Planes,
etc.)

© 2003, 2005 by the AICPA

 Largest Bankruptcy Filings
(1980 to Present)
from BankruptcyData.com

Company Assets (Billions) When Filed

1. WorldCom $103.9 July 2002
2. Enron $63.4 Dec. 2001
3. Conseco $61.4 Dec. 2002
4. Texaco $35.9 April 1987
5. Financial Corp of America $33.9 Sept. 1988
6. Global Crossing $30.2 Jan. 2002
7. PG&E $29.8 April 2001
8. UAL $25.2 Dec. 2002
9. Adelphia $21.5 June 2002
10. MCorp $20.2 March 1989

© 2003, 2005 by the AICPA

Why so many financial statement
frauds all of a sudden?
Good economy was masking many problems
Moral decay in society
Executive incentives
Wall Street expectations—rewards for short-term
behavior
Nature of accounting rules
Behavior of CPA firms
Greed by investment banks, commercial banks,
and investors
Educator failures

© 2003, 2005 by the AICPA

 Good economy was masking
problems…
With increasing stock prices, increasing profits
and increasing wealth for everyone, no one
worried about potential problems.
How to value a dot.com company:
– Take their loss for the year
– Multiply the result by negative 1 to make it positive
– Multiply that number by at least 100
– If stock price is less than the result…buy; if not, buy
anyway

© 2003, 2005 by the AICPA

 Executive Incentives
Meeting Wall Street’s Expectations
– Stock prices are tied to meeting Wall Street’s
earnings forecasts
– Focus is on short-term performance only
– Companies are heavily punished for not meeting
forecasts
– Executives have been endowed with hundreds of
millions of dollars worth of stock options—far exceeds
compensation (tied to stock price)
– Performance is based on earnings & stock price

© 2003, 2005 by the AICPA

 Incentives for F.S. Fraud
Incentives to commit financial statement fraud are very
strong. Investors want decreased risk and high returns.
Risk is reduced when variability of earnings is decreased.
Rewards are increased when income continuously improves.

Firm A Firm B

Which firm will have the higher stock price?

© 2003, 2005 by the AICPA
 Nature of Accounting Rules
In the U.S., accounting standards are “rules-
based” instead of “principles based.”
– Allows companies and auditors to be extremely
creative when not specifically prohibited by standards.
– Examples are SPEs and other types of off-balance
sheet financing, revenue recognition approaches,
merger reserves, pension accounting, and other
accounting schemes.
– When the client pushes, without specific rules in every
situation, there is no room for the auditors to say,
“You can’t do this…because it isn’t GAAP…”
– It is impossible to make rules for every situation

© 2003, 2005 by the AICPA

 Auditors—the CPAs
Failed to accept responsibility for fraud detection (SEC,
Supreme Court, public expects them to detect fraud) If
auditors aren’t the watchdogs, then who is?
Became greedy--$500,000 per year per partner
compensation wasn’t enough; saw everyone else getting
rich
Audit became a loss leader
– Easier to sell lucrative consulting services from the inside
– Became largest consulting firms in the U.S. very quickly
(Andersen Consulting grew to compete with Accenture)
A few auditors got too close to their clients
Entire industry, especially Arthur Andersen, was
punished for actions of a few

© 2003, 2005 by the AICPA

 Educators
Need to teach Ethics more
Need to teach students about fraud—offer
a “fraud” course
Need to teach students how to think
– We have taught them how to copy, not think
– We have asked them to memorize, not think
– We have done what is easiest for us and
easiest for our students

© 2003, 2005 by the AICPA

 Financial Statement Frauds
Revenue/Accounts Receivable Frauds (Global
Crossing, Quest, ZZZZ Best)
Inventory/Cost of Goods Sold Frauds
(PharMor)
Understating Liability/Expense Frauds (Enron)
Overstating Asset Frauds (WorldCom)
Overall Misrepresentation (Bre-X Minerals)

© 2003, 2005 by the AICPA

 Revenue Related Financial
Statement Frauds
By far, the most common accounts
manipulated when perpetrating financial
statement fraud are revenues and/or
accounts receivable.

Accounts Receivable xxx

Revenues xxx
(Income Assets )
© 2003, 2005 by the AICPA
 Revenue-Related Transactions and Frauds
Transaction Accounts Involved Fraud Schemes
1. Estimate all Bad debt expense, 1. Understate allowance for doubtful
uncollectible allowance for accounts, thus overstating receivables
accounts receivable doubtful accounts
2. Sell goods and/or Accounts receivable, 2. Record fictitious sales (related parties,
services to revenues (e.g. sales sham sales, sales with conditions,
customers revenue) (Note: cost consignment sales, etc.)
of goods sold part of 3. Recognize revenues too early (improper
entryh is included in cutoff, percentage of completion, etc.)
Chapter 5) 4. Overstate real sales (alter contracts,
inflate amounts, etc.)
3. Accept returned Sales returns, 5. Not record returned goods from
goods from accounts receivable customers
customers 6. Record returned goods after the end of
the period
4. Write off Allowance for 7. Not write off uncollectible receivables
receivables as doubtful accounts, 8. Write off uncollectible receivables in a
uncollectible accounts receivable later period
5. Collect cash after Cash, accounts 9. Record bank transfers as cash received
discount period receivable from customers
10. Manipulate cash received from related
parties
6. Collect cash within Cash, sales 11. Not recognize discounts given to
discount period discounts, accounts customers
receivable

© 2003, 2005 by the AICPA

 Overstating Inventory
The second most common way to commit
financial statement fraud is to overstate
inventory.
Beginning Inventory OK
Purchases OK
Goods Available for sale OK
Ending Inventory High
Cost of Goods Sold Low
Income High
© 2003, 2005 by the AICPA
 Inventory/Cost of Goods Sold Frauds
Transaction Accounts Involved Fraud Schemes
1. Purchase inventory Inventory, accounts 1. Under-record purchase
payable 2. Record purchases too late
3. Not record purchases
2. Return merchandise to Accounts payable, 4. Overstate returns
supplier inventory 5. Record returns in an earlier period (cutoff
problem)
3. Pay vendor w ithin Accounts payable, 6. Overstate discounts
discount period inventory, cash 7. Not reduce inventory cost
4. Pay vendor w ithout Accounts payable, cash Considered in another chapter
discount
5. Inventory is sold; cost Cost of goods sold, 8. Record at too low an amount
of goods sold is inventory 9. Not record cost of goods sold nor reduce
recognized inventory
6. Inventory becomes Loss on w rite-dow n of 10. Not w rite off or w rite dow n obsolete inventory
obsolete inventory, inventory
7. Inventory quantities Inventory shrinkage, 11. Over-estimate inventory (use incorrect ratios,
are estimated inventory etc.)
8. Inventory quantities Inventory shrinkage, 12. Over-count inventory (double counting, etc.)
are counted inventory
9. Inventory cost is Inventory, cost of goods 13. Incorrect costs are used
determined sold 14. Incorrect extensions are made
15. Record fictitious inventory

© 2003, 2005 by the AICPA

 Understating Liability Frauds
(3rd Most Common)
Not recording accounts payable
Not recording accrued liabilities
Recording unearned revenues as earned
Not recording warranty or service liabilities
Not recording loans or keep liabilities off
the books
Not recording contingent liabilities

© 2003, 2005 by the AICPA

 Asset Overstatement Frauds
(4th Most Common)
Overstatement of current assets (e.g.
marketable securities)
Overstating pension assets
Capitalizing as assets amounts that should be
expensed
Failing to record depreciation/amortization
expense
Overstating assets through mergers and
acquisitions
Overstating inventory and receivables (covered
earlier)

© 2003, 2005 by the AICPA

 Disclosure Frauds
Three Categories of Disclosure Frauds:
1. Overall misrepresentations about the nature of the
company or its products, usually made through news
reports, interviews, annual reports, and elsewhere

2. Misrepresentations in the management discussions

and other non-financial statement sections of annual
reports, 10-Ks, 10-Qs, and other reports

3. Misrepresentations in the footnotes to the financial

statements

© 2003, 2005 by the AICPA

 Detecting Financial Statement
Fraud
1. Management & Board 2. Relationships
With Others

Detecting Financial
Statement Fraud

3. Organization & Industry 4. Financial Results &

Operating Characteristics
© 2003, 2005 by the AICPA
 Enron Fraud
Compared to other financial statement frauds, Enron was very
complicated. WorldCom, for example, was a $7 billion fraud
that involved simply capitalizing expenses (line costs) that
should have been expensed (Accounting 200 topic). Enron
involved many complex transactions and accounting
issues.

“What we are looking at here is an example of

superbly complex financial reports. They didn’t have
to lie. All they had to do was to obfuscate it with sheer
complexity—although they probably lied too.”
Senator John Dingell

© 2003, 2005 by the AICPA

 Enron’s History
In 1985 after federal deregulation of natural gas
pipelines, Enron was born from the merger of Houston
Natural Gas and InterNorth, a Nebraska pipeline
company.
Enron incurred massive debt and no longer had exclusive
rights to its pipelines.
Needed new and innovative business strategy
Kenneth Lay, CEO, hired McKinsey & Company to assist
in developing business strategy. They assigned a young
consultant named Jeffrey Skilling.
His background was in banking and asset and liability
management.
His recommendation: that Enron create a “Gas Bank”—
to buy and sell gas

© 2003, 2005 by the AICPA

 Enron’s History (cont’d)
Created Energy derivative
Lay created a new division in 1990 called Enron Finance
Corp. and hired Skilling to run it
Enron soon had more contracts than any of its competitors
and, with market dominance, could predict future prices
with great accuracy, thereby guaranteeing superior profits.
Skilling hired the “best and brightest” traders and rewarded
them handsomely—the reward system was eat what you
kill
Fastow was a Kellogg MBA hired by Skilling in 1990—
Became CFO in 1998
Started Enron Online Trading in late 90s
Created Performance Review Committee (PRC) that
became known as the harshest employee ranking system
in the country---based on earnings generated, creating
fierce internal competition
© 2003, 2005 by the AICPA
 The Motivation
Enron delivered smoothly growing earnings (but not cash flows.)
Wall Street took Enron on its word but didn’t understand its financial
statements.

It was all about the price of the stock. Enron was a trading company
and Wall Street normally doesn’t reward volatile earnings of trading
companies. (Goldman Sacks is a trading company. Its stock price
was 20 times earnings while Enron’s was 70 times earnings.)

In its last 5 years, Enron reported 20 straight quarters of increasing

income.

Enron, that had once made its money from hard assets like pipelines,
generated more than 80% of its earnings from a vaguer business
known as “wholesale energy operations and services.”

© 2003, 2005 by the AICPA

 The Role of Stock Options
Enron (and many other companies) avoided
hundreds of millions of dollars in taxes by its use
of stock options. Corporate executives received
large quantities of stock options. When they
exercised these options, the company claimed
compensation expense on their tax returns.
Accounting rules let them omit that same
expense from the earnings statement. The
options only needed to be disclosed in a
footnote. Options allowed them to pay less
taxes and report higher earnings while, at the
same time, motivating them to manipulate
earnings and stock price.
© 2003, 2005 by the AICPA
 Enron’s Corporate Strategy
Was devoid of any boundary system
Enron’s core business was losing money—shifted its focus from
bricks-and-mortar energy business to trading of derivatives (most
derivatives profits were more imagined than real with many
employees lying and misstating systematically their profits and
losses in order to make their trading businesses appear less volatile
than they were)
During 2000, Enron’s derivatives-related assets increased from $2.2
billion to $12 billion and derivates-related liabilities increased from
$1.8 billion to $10.5 billion
Enron’s top management gave its managers a blank order to “just
do it”
Deals in unrelated areas such as weather derivatives, water
services, metals trading, broadband supply and power plant were all
justified.

© 2003, 2005 by the AICPA

 Aggressive Nature of Enron
Because Enron believed it was leading a
revolution, it pushed the rules.
Employees attempted to crush not just
outsiders but each other. Competition was
fierce among Enron traders, to the extent
that they were afraid to go to the bathroom
and leave their computer screen
unattended and available for perusal by
other traders.

© 2003, 2005 by the AICPA

 Enron’s Arrogance

Enron’s banner in lobby: Changed from

“The World’s Leading Energy Company”
to “THE WORLD’S LEADING COMPANY”

© 2003, 2005 by the AICPA

 2001 - Notable Events
Jeff Skilling left on August 14—gave no reason for his departure.
By mid-August , the stock price began to fall
Former CEO, Kenneth Lay, returned in August
Oct. 16…announced $618 million loss but not that it had written
down equity by $1.2 billion
October…Moody’s downgraded Enron’s debt
Nov. 8…Told investors they were restating earnings for the past
4 and ¾ years
Dec. 2…Filed bankruptcy

© 2003, 2005 by the AICPA

 Executives Abandon Enron
Rebecca Mark-Jusbasche, formerly CEO of Azurix, Enron’s troubled
water-services company left in August, 2000
Joseph Sutton, Vice Chairman of Enron, left in November, 2000.
Jay Clifford Baxter, Vice Chairman of Enron committed suicide in
May, 2001
Thomas White, Jr., Vice Chairman, left in May, 2001.
Lou Pai, Chairman of Enron Accelerator, departed in May 2001.
Kenneth Rice, CEO of Enron’s Broadband services, departed in
August 2001.
Jeffrey Skilling, Enron CEO, left on August 14, 2001

© 2003, 2005 by the AICPA

 Enron’s revenues and income
Year Revenues Income Income
(Restated)*
1997 $20.2 B $105 M $9 M

1998 $31.2 B $703 M $590 M

1999 $40.1 B $893 M $643 M

2000 $100.1 B $979 M $827 M

* Without LJM1, LJM2, Chewco and the “Four Raptors” partnerships. There
were hundreds of partnerships—mainly used to hide debt.
© 2003, 2005 by the AICPA
 “Value at Risk (VAR)” Methodology
Some warning signs disclosed by Frank Portnoy before January 24, 2002
Senate Hearings

Enron captured 95% confidence intervals for one-day holding periods

—didn’t disclose worst case scenarios
Relied on “professional judgment of experienced business and risk
managers” to assess worst case scenarios
Investors didn’t know how much risk Enron was taking
Enron had over 5,000 weather derivatives deals valued at over $4.5
billion—couldn’t be valued without professional judgment
From the 2000 annual report “In 2000, the value at risk model utilized
for equity trading market risk was refined to more closely correlate with
the valuation methodologies used for merchant activities.”
Given the failure of the risk and valuation models at a sophisticated
hedge funds such as Long-Term Capital Management—that employed
“rocket Scientists” and Nobel laureates to design sophisticated
computer models, Enron’s statement that it would “refine” its own
models should have raised concerns

© 2003, 2005 by the AICPA

 Special Purpose Entities (SPEs)
(Enron’s principal method of financial statement fraud involved the use of SPEs)

Originally had a good business purpose

Help finance large international projects (e.g. gas pipeline
in Central Asia)
Investors wanted risk and reward exposure limited to the
pipeline, not overall risks and rewards of the associated
company
Pipeline to be self-supported, independent entity with no
fear company would take over
SPE limited by its charter to those permitted activities only
Really a joint venture between sponsoring company and a
group of outside investors
Cash flows from the SPE operations are used to pay
investors

© 2003, 2005 by the AICPA

 Enron’s Use of Special Purpose
Entities (SPEs)
To hide bad investments and poor-performing assets
(Rhythms NetConnections). Declines in value of assets
would not be recognized by Enron (Mark to Market).
Earnings management—Blockbuster Video deal--$111
million gain (Bravehart, LJM1 and Chewco)
Quick execution of related-party transactions at desired
prices. (LJM1 and LJM2)
To report over $1 billion of false income
To hide debt (Borrowed money was not put on financial
statements of Enron)
To manipulate cash flows, especially in 4th quarters
Many SPE transactions were timed (or illegally back-
dated) just near end of quarters so that income could be
booked just in time and in amounts needed, to meet
investor expectations
© 2003, 2005 by the AICPA
 Accounting License to Cheat
Major issue is whether SPEs should be consolidated*—
SPEs are only valuable if unconsolidated.
1977--”Synthetic lease” rules (Off-balance sheet
financing) (Allowed even though owned more than 50%)
1984—”EITF 84-15” Grantor Trust Consolidations
(Permitted non-consolidation if owned more than 50%)
1990—”EITF 90-15” (The 3% rule) Allowed corporations
such as Enron to “not consolidate” if outsiders
contributed even 3% of the capital (the other 97% could
come from the company.) 90-15 was a license to create
imaginary profits and hide genuine losses. FAS 57
requires disclosure of these types of relationships.
3% rule was formalized with FAS 125 and FAS 140,
issued in September 2000.
*Usually entities must be consolidated if company owns 50% or more
© 2003, 2005 by the AICPA
 Mark-to-Market Accounting
Accounting and reporting standards for marketable securities,
derivatives and financial contracts are found in FAS 115 and FAS
133.
Changes in market values are reported in the income statement for
certain financial assets and in shareholders’ equity (component of
Accumulated Other Comprehensive Income) for others
Gains often determined by proprietary formulas depending on many
assumptions about interest rate, customers, costs and prices—
provides opportunities for management to create and manage
earnings
Enron often recognized revenue at the time contracts (even private)
were signed based on net present value of all future estimated
revenues and costs.
Profits really tracked price of oil futures—almost perfectly correlated

© 2003, 2005 by the AICPA

 The Chewco SPE
Accounted for 80% of SPE restatement or $400
million
In 1993, Enron and the California Public
Employees Retirement System (CalPERS)
formed a 50/50 partnership—Joint Energy
Development Investments Limited (JEDI)
In 1997, Enron bought out CalPERS’ interest in
JEDI
Half of the $11.4 million that bought the 3%
involved cash collateral provided by Enron—
meaning only 1 and ½ percent was owned by
outsiders
© 2003, 2005 by the AICPA
 LJM1 SPE
Responsible for 20% of SPE restatement or
$100 million
Should have been consolidated—an error in
judgment by Andersen (per Andersen)
After Andersen’s initial review in 1999, Enron
created a subsidiary within LJM1, referred to as
Swap Sub. As a result, the 3% rule for residual
equity was no longer met.
Andersen was reviewing this transaction again
at the time problems were made public—
involved complex issues concerning the
valuation of various assets and liabilities.
© 2003, 2005 by the AICPA
 Enron’s Disclosures
SEC Regulation S-K requires description of
related-party transactions that exceed $60K and
for which an executive has a material interest

“Related Party Transactions” footnote included

in Forms 10-Q and 10-K beginning with second
quarter of 1999 through 2nd quarter of 2001
From 2000 annual report “…Enron entered into
transactions with limited partnerships whose
general partner’s managing partner is a senior
official of Enron.” (Fastow)

© 2003, 2005 by the AICPA

 Enron’s Footnotes—Disclosures of
Enron Partnership
Report Footnote Filed with the
SEC
10Q—Q1 2000 Footnote 7 5/15/2000
10Q—Q2 2000 Footnote 8 8/14/2000
10Q—Q3 2000 Footnote 10 11/14/2000
10Q—Q1 2001 Footnote 8 5/15/2001
10Q—Q2 2001 Footnote 8 8/14/2001
10Q—Q3 2001 Footnote 4 11/19/2001
© 2003, 2005 by the AICPA
 The Famous “Misleading Earnings
Release” on October 16, 2001
Headline: “Enron Reports Recurring Third Quarter
Earnings of $0.43 per diluted share…”
Projected recurring earnings for 2002 of $2.15
If you dug deep, you learned that Enron actually lost
$618 million or $0.84 per share—they had mislabeled
$1.01 billion of expenses and losses as non-recurring.
Shockingly, there was no balance sheet or cash flow
information with the release
There was no mention of a $1.2 billion charge against
shareholder’s equity, including what was described as a
$1 billion correction to an accounting error. (This was
learned a couple of days later.)

© 2003, 2005 by the AICPA

 Didn’t Anyone See Enron’s
Problems?

Enron grew to be the 7th largest Fortune 100

company while media hype and the stock
market euphoria reigned
But in late 2000 negative reports began to
originate from some skeptics

© 2003, 2005 by the AICPA

 The Skeptics
Jonathan Weil, “Energy traders cite gains,
but some math is missing,” The Wall
Street Journal (Texas ed.) 9/20/2000
Feb. 2001 analyst report from John S.
Herold, Inc. by Lou Gagliardi and John
Parry
Bethany McLean, “Is Enron overpriced?”
Fortune, 3/5/2001

© 2003, 2005 by the AICPA

 Enron’s Cash Flows
Enron’s cash flows bore little relationship to
earnings (a lot due to mark to market.) On the
balance sheet, debt climbed from $3.5 billion in
1996 to $13 billion in 2001.

Key Ratio
Net Income (from Operations*) – Cash Flow (from Operations**)
Net Income (from Operations)

Would expect to be about zero over time

*From the Income Statement
**From the Statement of Cash Flows
© 2003, 2005 by the AICPA
 Enron’s Cash Flow Ratio
4

2
1998
1
1999
0 2000
2001
-1

-2
3 6 9 Year
months months months

Negative Cash Flows: 1st three quarters in 1999, 1st three quarters in 2000,
1st two quarters in 2001.
© 2003, 2005 by the AICPA
 Role of Andersen
Was paid $52 million in 2000, the majority for non-audit related
consulting services.
Failed to spot many of Enron’s losses
Should have assessed Enron management’s internal controls on
derivatives trading—expressed approval of internal controls during
1998 through 2000
Kept a whole floor of auditors assigned at Enron year around
Enron was Andersen’s second largest client
Provided both external and internal audits
CFOs and controllers were former Andersen executives
Accused of document destruction—was criminally indicted
Went out of business
My partner friend “I had $4 million in my retirement account and I lost
it all.” Some partners who transferred to other firms now have two
equity loans and no retirement savings.

© 2003, 2005 by the AICPA

 Role of Investment & Commercial
Banks
Enron paid several hundred million in fees,
including fees for derivatives transactions.
None of these firms alerted investors about
derivatives problems at Enron.
In October, 2001, 16 of 17 security analysts
covering Enron still rated it a “strong buy” or
“buy.”
Example: One investment advisor purchased
7,583,900 shares of Enron for a state retirement
fund, much of it in September and October, 2001

© 2003, 2005 by the AICPA

 Role of Law Firms
Enron’s outside law firm was paid
substantial fees and had previously
employed Enron’s general counsel
Failed to correct or disclose problems
related to derivatives and special purpose
entities
Helped draft the legal documentation for
the SPEs

© 2003, 2005 by the AICPA

 Role of Credit Rating Agencies
The three major credit rating agencies—Moody’s,
Standard & Poor’s and Fitch/IBCA—received substantial
fees from Enron
Just weeks prior to Enron’s bankruptcy filing—after most
of the negative news was out and Enron’s stock was
trading for $3 per share—all three agencies still gave
investment grade ratings to Enron’s debt.
These firms enjoy protection from outside competition
and liability under U.S. securities laws.
Being rated as “investment grade” was necessary to
make SPEs work

© 2003, 2005 by the AICPA

 So Why Did Enron Happen?
Individual and collective greed—company, its
employees, analysts, auditors, bankers, rating agencies
and investors—didn’t want to believe the company
looked too good to be true
Atmosphere of market euphoria and corporate arrogance
High risk deals that went sour
Deceptive reporting practices—lack of transparency in
reporting financial affairs
Unduly aggressive earnings targets and management
bonuses based on meeting targets
Excessive interest in maintaining stock prices

© 2003, 2005 by the AICPA

 Will there be another Enron?
Yes
– Recent years have seen an increase in the
number of financial statement frauds
1977-87 (300); 1987-1997 (300); 1997-2002 (over 300)
– Incentives still there (Stock Options, etc.)
No
– Sarbanes-Oxley Bill contains many key provisions
Executive “sign off”
Requirement to have internal controls
Rules for accountants (mandatory audit partner rotation;
Oversight Board, limitations on services, etc.)
– Accountants are being much more careful

© 2003, 2005 by the AICPA