BKAA 3023

Auditing and Assurance II

Case 4.1

Enron Corporation and Andersen,

LLP
SEMESTER 1 SESSION 2015/2016

Group K (3)
LECTURERS NAME
MOHD RAIME B RAMLAN

Group Members Details

1. [ 225767 ] Nik Ahmad Hafizuddin Bin Nik Abdul Aziz

2. [ 225907 ] Thivia Jyothi A/P Giamasrow
3. [ 227109 ] Lee Zi Cong
4. [ 227159 ] Khalimatul Saadiah Binti Khaider
5. [ 227198 ] Nur Hazwani Bt Mohamad Zwawi

Enron Corporation and Andersen, LLP 3023

1. What were the business risks Enron faced, and how did those risks increase the
likelihood of material misstatements in Enrons financial statements?
Business risk is the probability of loss inherent in an organizations operations and
environment such as competition and adverse economic conditions that may impair its ability
to provide returns on investment. It also implies uncertainty in profits or danger of loss and
the events that could pose a risk due to some unforeseen events in future, which causes
business to fail. For example, an owner of business may face different risk like in production,
risk due to irregular supply of raw materials, machinery breakdown, labour unrest. Business
risk can major by the influence by two major risk which is internal risk and external risk
where the internal risk arising from the events taking place within the organization while
external risks arising from the events taking place outside the organization.
Business risks also the probability that a company will have lower than anticipated
profits, or that it will experience a loss rather than profit. Business risk is influenced by
numerous factors, including sales volume, per-unit price, input costs, competition, overall
economic climate and government regulations. A company with higher business risk should
choose a capital structure that has a lower debt ratio to ensure that it can meet its financial
obligations at all times.
The business risks Enron faced when borrowed funds with high stock prices and
operating the borrowed funds as revenue, and never reporting as liabilities because Enron put
much pressure on itself to continue to look highly profitable to continue in increase the stock
valuation. This will lead more investors to put more money into the company, which greatly
increase the likelihood of material misstatements. Enron also faced by any energy company,
including price instability and foreign currency risks. This is because Enron operated in many
different areas with different regulatory and political risks. This will affect the company to
much additional risk, which created pressure to adopt aggressive financial reporting practice.

Enron Corporation and Andersen, LLP 3023

2. (a) What are responsibilities of a companys board of directors? (b) Could the
board of directors at Enron-especially the audit committee-have prevented the
fall of Enron? (c) Should they have known about the risks and apparent lack of
independence with Enrons SPEs? What should they have done about it?
(a)

The responsibilities of a companys board of directors are responsible for

ensuring that firms management is acting in the best interest of owners. They could have
taken several steps to improve corporate. They also responsible to recruiting, supervising,
retaining, evaluating and compensating the CEO or general manager are probably the most
important functions of the board of directors. Value-added business boards need to
aggressively search for the best possible candidate for this position. Actively searching within
your industry can lead to the identification of very capable people. Dont fall into the trap of
hiring someone to manage the business because he/she is out of work and needs a job.
Another major error of value-added businesses is under-compensating the manager.
Managerial compensation can provide a good financial payoff in terms of attracting top
candidates who will bring financial success to the value-added business. Board of directors
also must provide direction for the organization. The board has a strategic function in
providing the vision, mission and goals of the organization. These are often determined in
combination with the CEO or general manager of the business. Lastly, board of directors
must establish a policy based governance system. The board has the responsibility of
developing a governance system for the business. The articles of governance provide a
framework but the board develops a series of policies. This refers to the board as a group and
focuses on defining the rules of the group and how it will function. In a sense, its no different
than a club. The rules that the board establishes for the company should be policy based. In
other words, the board develops policies to guide its own actions and the actions of the
manager. The policies should be broad and not rigidly defined as to allow the board and
manager leeway in achieving the goals of the business.

Enron Corporation and Andersen, LLP 3023

(b)

In the reports following the fall of Enron the committees placed a good deal of

blame on board of directors and audit committee. They could have prohibited accounting
practices and transactions that put the company at high risk. They also must have prohibited
conflict of interest arrangement that allow company transactions with a business owned and
off-the-book activity in that company. They must be preventing stock based compensations
plans that encourage use of improper accounting and must increase independency-requiring a
majority of outside directors to be free of material financial ties to the company without left
the strengthen external auditors independence.
(c)

The audit firm is of course responsibility for their own work. The audit report

did not include the modifications that should have been there. In order to fulfil their task and
provide high quality audit they should have prevented the aggressive accounting produced by
Enron. Enron was experiencing unprecedented growth and leveraged high stock in late 1990.
This transaction called as special purpose entities (SPEs). It leads Enron received
borrowed loans that appeared as revenue, without any liability on the balance sheet, and were
guaranteed by Enron stock. So the companys board of directors is supposed to act as
shareholder representation and assist with policies and issues. The board of directors could
have taken a further look into the special purpose entities that were occurring to prevent the
fall of Enron. They should have known about the issues with the SPEs especially the amount
of transactions, and put an end to continued transactions and make the necessary corrections
for financial reporting. I think that the board of directors could have changed some policies,
been more aware of the risk involving the SPEs instead of letting things unfold the way that
they did. The Board of Directors could have researched SPEs and learned more about the
way they work, not to mention finding out to account for them on financial statements. There
should have been policies in place regarding employee stock options, putting a limit on how
much they bought or even sold at the time. They also knew about the risk and apparent lack
of independence with the SPEs. They should have objected to the formation of and
transactions with the SPEs but they instead suggested means of enabling this practice.

Enron Corporation and Andersen, LLP 3023

3. In your own words, summarize how Enron used SPEs to hide large amounts of
company debt.
SPEs is entities were at the centre of Enrons aggressive business and accounting
practices. It set up to accomplish specific company objectives and help company sell off
assets. The SPE would pay for the contributed assets through a new debt or equity issuance. It
can recognize the sale of assets to the SPE and thereby remove the assets and any related
debts from its balance sheets. SPE have been controversial in corporate America. Accounting
rules dictate that once a company owns 50% or more of another, the company must
consolidate, thus including the related entity in its own financial statements. Enron used an
intricate network of SPEs along with complicated speculations and hedges. Enron SPEs have
been made prominent throughout the congressional hearings and litigation proceedings which
is Chewco, LJM2, and Whitewing. Chewco established in 1997 by Enron executive in
connection with a complex investment in another Enron partnership with interest in natural
gas pipelines. LJM2 partnership formed in 1999 with the goal of acquiring assets chiefly
owned by Enron. The Whitewing purchased an assortment of power plants, pipelines, and
water projects originally purchased by Enron in mid 1990s that located in India, Turkey,
Spain and Latin America. Enron created financial instruments called Raptors which were
backed by Enron stock and were designed to reduce the risks associated with Enrons own
investment portfolio.
4. What are the auditor independence issues surrounding the provision of external
auditing services, internal auditing services, and management consulting services
for the same client? Develop arguments for why auditors should be allowed to
perform these services for the same for client. Develop separate arguments for
why auditors should not be allowed to perform non-audit services for their audit
clients. What do you believe?
Non-audit services provide by auditors to their clients fall into three categories. First is a
service required by legislation or contract to be undertaken by the auditors of the business.
This is include regulatory returns, legal requirements to report on matters such as share issues
for non-cash consideration, expenditure for grant application purposes and contractual
requirements, for example to report to lenders or vendors on net assets. Other than that,
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services that it is most efficient for the auditors to provide because of their existing
knowledge of the business, or because the information required is a by-product of the audit
process. These include services such as auditors are not required by law to undertake, but
where the information largely derives from the audited financial records. The tax compliance,
where much of the information derives from the audited financial records. Lastly, services
that could be provided by a number of firms. In this case, the fact that the firm is the auditor
is incidental and it would generally only be chosen because, for example, it had won a tender
process. Examples of such services include management consultancy, tax advice and human
resources consultancy. Internal auditing services is a trusted advisor that can help address
risks and steer clear of obstacles that could block the path to organizations goals and improve
bottom-line results along the way.
In our opinion, auditors are allowed to perform non audit services for their audit client as
long as there are not conflict with auditor independence and professionals standard.
Concerns about auditors providing non-audit services to the companies they audit are based
largely on the view that this threatens auditor independence, objectivity and professional
scepticism. The argument is that auditors will not want to risk the fees they are receiving
from non-audit services and therefore may not raise the questions or challenges that are
warranted. Some even suggest that, in extreme cases, an audit firm could become
economically dependent on a company it audits due to the fees from non-audit services.
Another argument is that audit firms will be so absorbed in growing their non-audit services
practices that they will be distracted from their focus on audit. Proponents of auditors
providing non-audit services to the companies they audit believe that providing such services
helps auditors build a deeper understanding of the audited company, including its business
model, strategy, risk, competitive position and industry. This furthers the auditors insight and
can enhance professional scepticism, thereby increasing audit quality. Other than that, Audit
committees should have clear authority to oversee the entire audit process and to appoint and
remove the auditor. They also should be well-resourced, and their members should be
independent and highly qualified. As part of their oversight of the auditor, audit committees
should, on a periodic basis, conduct a robust assessment of the auditors independence and
objectivity and make this publicly available.

Enron Corporation and Andersen, LLP 3023

5. Explain how rules-based accounting standards differ from principles-based
standards. How might fundamentally changing accounting standards from
bright-line rules to principle-based standards help prevent another Enron-like
fiasco in the future? Are there dangers in removing bright-line rules? What
difficulties might be associated with such a change?
Rules-based accounting is sets of accounting standards in the form of detailed rules. It is
very specific but also very complicated because many rules are needed to cover the numerous
situations accountants face when preparing financial statements. Rules-based system
approaches financial reporting as an act of compliance and attempts to tell prepares what to
do as it uses a check-box mentality. Principles-based accounting avoids rules in favour of
general guidelines. Instead of having to comply with hard and fast dictates, accountant uses
general principles to guide him/her professional judgments. Principle-based system acts as a
communication link between preparers and attempts to guide practitioners (preparers and
auditors) in deciding what need to be done when reporting financial information.
Instead of the one size fits all rule-based approach that was adopted by the USA namely
Sarbanes-Oxley Act, 2002, principle-based governance approach is more flexible. Adopting
the principle-based approach will minimize the compliance costs. Principle-based governance
approach has allows different industries to develop industry specific governance structures. A
principle-based approach would not eliminate the need for interpretive and implementation
guidance. Under a principle-based approach, one starts with laying out the key objectives of
good reporting in the subject area and then provide guidance explaining the objective and
relating it to some common examples. Sometimes, rules are unavoidable and the guidance
should be sufficient to enable proper implementation of the principles, but the intention is not
trying to provide specific rules for every situation, it should be the reader to be directed to the
principles. Principles-based approach would require participants to exercise good
professional judgment and resist the urge to seek specific answers and rulings on every
implementation issues.
The advantages of implementing rules-based approach are clarity in application, risk
reduction (only when the applicable rule is followed), and comparability for companies in the
same industry for the same rule. Removing rules-based approach will cause the accounting to
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be unclear in the way of application as it is not prepared in the rules provided. Removing the
rules-based approach also rise up the risk in doing accounting because rules are not to be
follow and some unethical person may take advantage in committing fraud. Companies of the
same industry are hardly to be comparable because the approach implemented in each
company is different.
Some difficulties would be faced in adaption of international accounting standards as it
moves toward more principles-based standards. Firstly, the measurement of principles-based
standards is inconsistent because it requires a significant number of guidance for management
decision making. The more decisions making required by an accounting principle, the greater
the difficulty it is to implement it into a standard without sufficient guidance and, maybe,
exceptions. Implementing principles-based standard will also decreases the comparability.
Accounting information may begin to be less consistent as principles are used rather than
rules. This is because it is possible that different opinions may came out from two
accountants in interpreting the same set of data. Besides, compliance to principle-based
standard is more complex, expensive and time-consuming. Accountants with vast experience
is required if the company needs to constantly interpret principles, and they must be expert in
understanding the accounting framework. Thus, more time is required in making decision and
conclusion. The enforcement of the standard is even harder. As companies are constantly
accused of misstating financial information, it would be bad to ask judges and juries with no
financial experience to interpret accounting principles during enforcement cases. Courts are
having hard times in making conclusion based on explicit accounting rules, if principle-based
standard is to be implemented, it could be even worse to the courts in making judgments.

Enron Corporation and Andersen, LLP 3023

6. Enron and Andersen suffered severe consequences because of their perceived
lack of integrity and damaged reputations. In fact, some people believe the fall of
Enron occurred because of a run on the bank. Some argue that Andersen
experienced a similar run on the bank as many top clients quickly fired the
firm in the wake of Enrons collapse. Is the run on the bank analogy valid for
both firms? Why or why not?
Run on the bank refers to a situation when in a fractional-reserve banking system, a large
number of customers withdraw cash from deposit accounts with a financial institution at the
same time because they believe that the financial institution is or might become insolvent.
Enron has greatly shows its likelihood to the valid of run on the bank analogy. Enron
appeared to become a wildly successful company by creating a new largely unregulated
financial business, that of energy trading. That business ran on credit, and required suppliers
and users of energy to sign contracts that called on Enron to meet obligations month or years
later. Enron became something like a bank, which takes depositors money and promises to
pay it back later. But unlike banks in the current era, this institution had no federal deposit
insurance to reassure customers when rumours began to spread that it was in trouble. That
proved to be its Achilles hill. Enrons collapse is a reminder for big players in unregulated
markets that their financial health must be beyond doubt.
Anderson as well is likely to the valid of run on the bank analogy. By 1979, 42% of
Andersons $645 million in worldwide fees came from consulting and tax work, as opposed
to accounting and auditing. More than half its income came from non-audit services,
according to Kapnick, the chairman of the firm. As client like Enron took more prominence at
Andersen, consulting was securing its dominance. By 1994, 2/3 of Andersens $3.3 billion in
U.S. revenue came from the consulting side. Coinciding with that shift, the influence of the
firms in-house ethics watchdog dimmed. In the aftermath of Enrons collapse , Anderson
began to unravel quickly, losing over 400 publicly trade clients by June 2002, including many
high-profile clients with which Andersen enjoyed long relationships. In addition to losing
clients, Andersen lost many of its global practice units to the rival accounting and consulting
firms, and agreed to sell a major portion of its consulting business to KPMG consulting for
$284 million as well as most of its tax advisory practice to Deloitte & Touche. A federal
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appeals court has overturned a $5 million judgment that ordered the insurer of defunct auditor
Arthur Andersen LLP to cover the firms liability to retired employees who lost their pensions
when Enron collapsed. The circuit judges said: If Arthur Andersen paid 100% to the retirees
who got in line first, the rest stood to receive nothing. If it stopped all lump-sum distribution,
then it might be able to pay some portion of all retirees claims. That created the equivalent of
a run on the bank.
7. A perceived lack of integrity caused irreparable damage to both Anderson and
Enron. How can you apply the principles learned in this case personally?
Generate an example of how involvement in unethical activities, or even the
appearance of such involvement, might adversely affect you career. What are the
possible consequences when others question your integrity? What can you do to
preserve your reputation throughout your career?
When we look at the Enron and Andersen case, we can take a lot of lessons. These
include the fact that greed can often lead to people making irresponsible decisions and
personal gain through money should not be the driving force of how you make decisions.
Enron executives personally made millions off of the run-up in stock price and Andersen
retained a $50 million by not reporting the facts. They did not apply their integrity in
consideration when committing these illegal acts. Lack of integrity, can cause damage to a
career in many ways. Integrity is an important foundation in client and employee or employer
relationships. Integrity equates to placing trust in an individual that he or she will conduct
themselves with ethical and moral standards. Studying the damage caused to Andersen and
Enron is a good example to conduct oneself with a high standard and not engage in activities
at our outside of work which would cause someone to question your integrity as well as the
trust relationship. We also can avoid any incidents that affect our career.
An example of involvement in unethical or illegal activities, or the appearance of
involvement which may adversely affect your career, would be participation in gambling.
While this activity is legal in some states and venues, this activity could be extrapolated to
ones personality which could go against the moral of integrity of clients or supervisors.

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Since this is a perceived negative activity, a client or employer might wonder what risks
of integrity or moral standards the firm applies in their work activities. When this happens,
clients or company may lose trust in the audit firm and decide to work with someone else or
you may be overlooked for promotion or have other negative consequences.
To preserve your reputation throughout your career, one should always present yourself
honestly and avoid situations that may be questionable always conduct themselves with high
ethical and moral standards to maintain their integrity. This would include judgment and
decisions made should be true and fair at work as well as activities engaged in outside of
work. In order to avoid these situations, always conduct themselves with high ethical and
moral standards to maintain their integrity. The backup of facts or written documentation can
help you to avoid this and knowing when to involve higher levels or a third party when you
discover illegal or unethical behaviour is important to maintaining integrity.
8. Why do audit partners struggles with making tough accounting decisions that
may be contrary to their clients position on the issue? What changes should be
profession make to eliminate these obstacles?
Audit partners can struggle with making decisions that are contrary to their clients
because it can force them to ultimately lose the client if they push for what they believe to be
the right and ethical move. Public accounting is service-oriented business and it holds a trust
of lot of people. As with most of the other service-offering enterprises, public accounting
firms have a vital interest in pleasing their clients by providing value and excellent customer
service. In order to provide excellent client service, and maintain good relationship with the
clients partners do not oppose the clients accounting choices even if they are not up the
accounting standards. This happen due to huge competition in the market and partners are
afraid they might lose the business. The client can perceive the auditor as a threat to their
business for doing their jobs and highlighting material misstatements that could potentially
affect the clients ability to run the business even though its the right and legal thing to do.
Like other business, public accounting firms are also in the business to make money. As
owners of a public accounting firm, are naturally interested in the financial performance of
the firm because, their income and bonuses depend on annual revenues. One interesting note
is that audit fee revenues from such companies as Enron are very lucrative, that is Andersens
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audit fee at Enron was about $48 million per year. In the year 2000 Anderson LLP earned
more consulting fees than their auditing fees for the same year. This suggests how important
it is for the partners to make money than rather providing the services that they are known
for.
In order to eliminate these obstacles, auditors need to be committed to putting the public
interest first. They should work for public interest and not be scared by the boss. They should
bring to the notice of the management if they find some fraud in financial statements of the
company. By laying this foundation, difficult decisions will be easier to make when such
circumstances arise. They should produce true and fair report. If there are misstatements in
the financial statement, they should give qualified audit report. Public depends on this audit
report to take their decision regarding the company. As auditors, have to present unqualified
report to them.
9. What has been done, and what more can be done to restore the public trust in
the auditing profession and in the nations financial reporting system?
The enactment of the Sarbanes-Oxley Act of 2002 was an effort to make changes to
restore public trust in both the accounting profession and financial reporting performed by
companies. Given the problems in the case of Arthur Andersen and Enron where both the
external audit firm and management made unethical decisions which caused public trust to
decrease, these changes were necessary.
The Sarbanes-Oxley Act requires companies to revaluate their internal audit procedures
and make sure that everything is running up to or exceeding the expectations of the auditors.
It also requires higher level employees, like the CEO and CFO to have an understanding of
the workings of the companies that they head and to affirm the fact that they dont know of
any fraud being committed by the company.

Sarbanes-Oxley also makes the new

requirements for disclosures.

Sarbanes-Oxley Act also mandated the creation of an oversight board, the Public
Company Accounting Oversight Board (PCAOB) that is under the Securities & Exchange
Commission (SEC) jurisdiction. This move essentially ended the accounting professions
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tradition of self-regulation. The PCAOB has the authority over audit forms auditing any SEC
clients in the United States. The major stock exchanges in the United States are taking into
consideration different reforms and listing requirements to help strengthen board of director
governance over senior management. These steps that are being taken will help to restore
confidence in the capital markets. Companies must continuously demonstrate their
commitment to disclose financial and operational information accurately. The processes must
maintain and enhance the quality of the information provided to creditors, investors, and
other users of the financial information included in the financial statements.
Besides auditing profession, there is the issue of accounting standards themselves.
Enron's behaviour has confirmed that in some areas American accounting standards are too
lack. It is time for the SEC itself to impose more rigorous standards, although that should
often be through sound principles rather than overly detailed rules. It would also be good to
come up with internationally agreed standards.
The American Institute of Certified Public Accountants (AICPA) has been engaged in
significant damage control measures to restore confidence in the profession. The AICPA
made several new Statements on Auditing Standards in response to the Enron events. The
three that appear to be most closely linked to the Enron and Andersen debacle are SAS 96,
SAS 98, and SAS 99. SAS 96 became effective January of 2002 and dealt with the record
retention policies of accounting firms. In SAS 96 the requirements of SAS 41, which was the
first SAS to address record retention, were reaffirmed. Also several new regulations were
added. SAS 96 contains a list of factors that auditors should consider when attempting to
determine the nature and extent of documentation for a particular audit area and procedure. It
also requires auditors to document all decisions or judgments that are of a significant degree.
For example, a decision of a significant degree would be an auditor approving a client not
using Generally Accepted Accounting Principles (GAAP) for a portion of their financial
statements. These changes appear to be a direct result of the paper shredding that went on at
Arthur Andersen immediately after the Enron bankruptcy. SAS 98 makes a lot of revisions
and amendments to previous statements.

These changes include changes to Generally

Accepted Auditing Standard (GAAS), changes to the relationship between GAAS and quality
control standards, and audit risk and materiality concepts in audits. All of these changes
would appear to be related to problems that were discovered in the Andersen audit of Enron.
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SAS 99 outlines what fraud is, reaffirms the auditors responsibility to look for fraud, and
reaffirms the necessity to gather all information for an audit. These changes appear to be in
connection to the fact that Anderson did not find any fraud in Enrons books, where fraud
existed.

These changes all came from within the AICPA. Many accounting firms and

independent CPAs reacted to these events and implemented changes in procedure voluntarily.
The AICPA board of directors would cooperate fully with the SECs proposal for new
rules for the peer review and disciplinary process for Certified Public Accountant (CPA)
firms of SEC registrants. The new system would be managed by a board, a majority of which
would be public members, enhancing the peer review process for the largest firms and
requiring more rigorous and continuous monitoring. The staff of the new board would
administer the reviews.
In Malaysia, the corporate scandals call for an overhaul to the field of accounting and
auditing. It calls for regulators to look into enforcing By-Laws, redefining functions of
auditors, addressing roles of audit committee and internal auditors and exploring the impact
of audit quality on financial users. To ensure auditors possess the professions ethical values,
Malaysian Institute of Accountants (MIA) issues its professional code of ethics. Ethics is
about principles that are innate; it goes beyond obeying laws, rules and regulations. The
purpose of these ethical codes is to help auditors identify what are considered as ethically
right or wrong. Moreover, it is hoped that these ethical codes will hinder auditors from
forming unethical judgments and thus prevent financial scandals. In acting in the public
interest, a professional accountant should observe and comply with the ethical requirement of
the By-Laws that have been framed with the objective that members exhibit the highest
standards of professionalism and professional conduct that are expected of the profession.
In future, auditor of the company should be informed about the financial or operational
aspects of the company in a timely manner to prevent the company from manipulate any of
their data or financial statement. Auditor should alert when there are rapid growth that happen
in the one organization. This can happen when the company make drastic changes in
accounting practices to boost their earnings. They must compare practices or techniques that
used by the company with the industry standards and demand reasonable explanations from
the company.
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