MZUMBE UNIVERSITY DAR ES SALAAM BUSINESS SCHOOL FACULTY OF COMMERCE

PROGRAMME: MSc. ACCOUNTING AND FINANCE

SUBJECT: ACC 5221: AUDITING AND ASSURANCE SERVICES LECTURER: TITLE: NAME: E.S. Malubi & S.R.Mngoya TERM PAPER NGODA, G

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Discuss why, in 2002, the corporate governance structures failed both Enron and WorldCom and what would have been done by

the auditors in order to prevent the failures.

DATE:

3RD JANUARY 2011

Question Both Enron and WorldCom had corporate governance structure in place including presence of Board of Directors and audit committees composed of appropriately qualified persons. For example, Enron had and an independent Board of Directors of seventeen members, only two of whom were insiders and the rest were Chief Executive Officers of other companies, government officials and academicians. The Enrons audit committee was composed entirely of independent directors and was headed by former professor of accounting at Stanford Business School. Both Enron and WorldCom were being audited by Arthur Andersen, one of the big five and most respected audit firms in the world. Required: Discuss why, in 2002, the corporate governance structures failed in both Enron and WorldCom and what would have been done by the auditors in order to prevent the failures.

TABLE OF CONTENTS 1.0 2.0 Introduction...3 Corporate governance.. ...4 2.1 Corporate Governance in Enron..4 Corporate Governance in WorldCom. .4

2.2

3.0

Reason for failure of corporate governance..............4 3.1 Failure of corporate governance at Enron in 2002 5 Failure of corporate governance at WorldCom in 20027

3.2

4.0 5.0

Reasons for audit failure...8 What would have been done by Auditors. 9 Conclusion and recommendation..... ...10

6.0

Bibliography.11

1.0

INTRODUCTION

CORPORATE GOVERNANCE Corporate governance has a great role in transparency and honesty in financial reporting. Corporate governance then implies relationships among an organizations management, the board, the stakeholders, and other bodies that have indirect involvement with the company. 1 It also provides a generalized structure from which the organizations objectives emerge. However the process whereby directors of a company are monitored and controlled, involves decision making, accountability and monitoring is also defined as corporate governance.2 Two aspects which are considered to be fundamental to corporate governance are: Supervision and monitoring of management performance (the enterprise aspect) and ensuring accountability of management to shareholders and other stakeholders. The failures of high-profile Company like Enron and WorldCom raise the question of regulatory system as well as serious issues about the effectiveness of the governance of these companies. Enron A Brief background
Victor Gaines, the Role of Corporate Governance in the Financial Institution Industry, http://www.theiia.org/download.cfm?file=28127(accessed on December 21, 2010) 2 http://mpra.ub.uni-muenchen.de/15989/1/MPRA_paper_15989.pdf (accessed on December 21, 2010)
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Enron was created in 1985 from the merger of Houston Natural Gas and Intermonth, a Nebraska gas company. Enron rode, and evolved with, the deregulation of the United States energy markets through the late 1980s and 1990s. It progressively shed its physical assets to focus on trading and the development of complex derivative products. Over time it extended its trading activities to create markets for derivative products, including paper, coal, metals, telecommunications bandwidth and even weather. It was regarded as the model of a virtual, new-age company and in 2001 was named The Most Innovative Company in America. Over its 15 year history as Enron, its market capitalization grew from US$2 billion to US$70 billion.3
WorldCom A Brief background WorldCom, based in Mississippi, was a telecommunications company that emerged from obscurity during the frenzy of corporate activity in the sector unleashed by deregulation of the US telecommunications industry. Through a frenetic series of takeovers 72 over 17 years the company emerged as the second largest US long-distance carrier and developed the worlds largest Internet protocol network. At its peak it was valued at about US$180 billion. The improprieties involved treating items that should have been expensed as capital items, inflating the companys reported earnings and cash flows by at least US$3.9 billion over the five quarters to the end of March 2002. Had the items been expensed, WorldCom would have reported losses for that period rather than the US$2 billion of profits it claimed to have earned. The timing of the disclosure may have been a coincidence but WorldComs auditor, Andersen, was replaced by KPMG in May 2002. 3 2.0 CORPORATE GOVERNANCE 2.1 Corporate Governance in Enron

Stephen Bartholomeusz, After Enron: The new reform, http://www.austlii.edu.au/au/journals/UNSWLJ/2002/33.txt/cgi.../2002/33 .rtf (December 16, 2010)

In light view the company was operated and managed in governance with the presence of responsibility of directors, composition of the board and good internal control Enrons Board structure with five oversight subcommittees could have been characterized 29 as typical amongst major public American corporations. The Chairman of the Board was Kenneth Lay, and in 2001 Enron had 15 Board Members. Most of the members were then or had previously served as Chairman or CEO of a major corporation, and only one of the 15 was an executive of Enron, Jeffrey Skilling, the President and CEO. Enron managed their numbers to meet aggressive expectations. They were less concerned with the economic impact of their transactions as they were with the financial statement impact. The Board improperly allowed conflicts of interest with Enron partnerships and then did not ensure appropriate oversight of those relationships. There was a fundamental lack of communication and direction from the Board as to who should be reviewing the related-party transactions and the degree of such review. The Board was also unaware of other conflicts of interests with other transactions.4

2.2

Corporate Governance in WorldCom

Having the right people in place is critical to good governance at any company. The story of WorldComs corporate governance system illustrates the problems of a large company operating without a true independent board of directors. At issue, was the fact that WorldComs nine member board was composed of corporate insiders; friends of Bernard Ebbers and executives from the acquired companies. Most of WorldComs outside directors board did not have direct access or get involved with the companys day-to-day business operations. The outside directors had little or no contact with company employees other than during presentations at board meetings. Nor were there systems in place that would have allowed employees to contact the board with concerns about company finances or operational matters. Companys internal audit department or the Audit Committee
Peter Grosvenor Munzig, Enron and the Economics of Corporate Governance, http://www.economics.stanford.edu/files/Theses/Theses_2003/Munzig.pd (December 14,2010)
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perceived the widespread serious weaknesses in the Companys internal controls over external financial reporting.5

3.0

REASON FOR FAILURE OF CORPORATE GOVERNANCE 3.1 Failure of corporate governance at Enron in 2002

Conflicts of Interest One of the major governance issues brought to light by the bankruptcy of Enron was the blatant conflict of interest involved with having financial officers of a company both manage and be equity holders of entities that conducted significant business transactions with Enron. Enrons Code of Ethics and Business Affairs explicitly prohibits any transactions that involve related parties unless the Chairman and CEO determined that his participation does not adversely affect the best interests of the Company, a good example is how the Chewco transaction was handled6 Audit Committee: In the words of the Special Investigating Committee: "The Board assigned the Audit and Compliance Committee an expanded duty to review the transactions, but the Committee carried out the reviews only in a cursory way." The Chair of the Audit Committee since 1985 was Mr. Robert Jaedicke. Mr. Jaedicke, in addition to not using his expertise to perform his role as Chair of the committee, seconded the motion in the board to suspend the `Code of Ethics' of the company in order to allow an employee to set up a special partnership. Setting up that entity amounted to a conflict of interest and was specifically prohibited by the company code. Apart from Mr. Jaedicke, the audit committee comprised of five persons, three of whom reside outside the country. An audit committee is almost a `working' committee and needs to meet more frequently than a full board. One of the members, Mr. Ronnie Chan, missed 75 per cent of the meetings in 2001.6 Too many directorships: Good governance suggests that an individual sitting on too many boards looks upon it only as a sinecure for he or she will not have the
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http://www.cem.ulaval.ca/pdf/gershon_alhassan.pdf (December 17, 2010) Gopinath. C, Corporate governance failure at Enron http://www.thehindubusinessline.com/2002/03/04/stories/2002030400110900.htm (December 22,2010)

time to do a good job. Mr. Raymond Troubh, one of the directors, is a Director of 11 public companies. In Enron's case too many of their faults came together at the same time to cause the company to implode. 6 Chairman and Chief Executive Officer: Mr. Kenneth Lay was both the Chairman and Chief Executive Officer. For a brief while the two positions were separated when Mr. Jeff Skilling functioned as Chief Executive Officer, and when he resigned in August 2001, Mr. Lay again took on both roles. It is considered good practice to separate the roles of the Chairman of the Board and that of the Chief Executive Officer. 6 Flow of information: The Special Investigating Committee report says: "The board was denied important information that might have led it to action, but the Board also did not fully appreciate the significance of some of the specific information that came before it. Moreover, if they did not have sufficient information, they should have gone seeking it. Reports suggest that Enron operated about 3,500 Special Purpose Entities, that is, partnerships that shifted debt and losses off Enron's balance-sheet. If the directors did not understand what was being reported to them, it was their job to educate themselves more about it by asking the right questions and getting more information. This they failed to do.6 3.2 Failure of corporate governance at WorldCom in 2002

Independence of the Board For the board to be independence not more than two directors should be current or former company executives, this was not in the case of WorldCom. The board member was engaged in direct business dealings with the said company and accepts consulting fees for services rendered beyond that of an appointed board member5.

Quality of the Director WorldCom boards were not including a minimum of two independent directors with experience in the companys core business. Ideally, one of the board members should be a CEO of an equivalent size company.5 8

Make CEOs More Accountable The said board members proved to be ever loyal to CEO Ebbers. They, in turn, received multiple perks, including millions of dollars in WorldCom stock, use of the companys private jet and financial support to pursue a variety of individual projects.5

WorldCom seemed to meet most of the governance standards of its time. Indeed, in several areas WorldCom exceeded the accepted norms of best practice in corporate governance, even though there was little if anything about its governance that was good in reality. This illustrates the fact that good governance is not achieved by simply adhering to checklists of recommended best practices, but is a more complex equation that is highly dependent on the attitudes and actions or inactions of the people involved. While not found in most descriptions of director qualifications, backbone and fortitude may be the most important qualities needed by a director of a public company.7 Ebbers controlled the boards agenda, the timing and the scope of board review of transactions, awards of compensation, and the structure of management. He ran the Company with iron control, and the board did not establish itself as an independent force within the Company. The Chairman of the Board did not have a defined role of substance, did not control the boards agenda, did not run the meetings and did not act as a meaningful restraint on Ebbers. WorldComs collapse reflected not only a financial fraud but also a major failure of corporate governance. The Board of Directors, though apparently unaware of the fraud, played far too small a role in the life, direction and culture of the Company 5

4.0
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REASON FOR AUDIT FAILURE

http://www.cem.ulaval.ca/pdf/gershon_alhassan.pdf

Breeden, Richard C., Restoring trust, http://news.findlaw.com/hdocs/docs/worldcom/corpgov82603rpt.pdf ( December 22, 2010)

The reason of great audit failure was mainly lack of independence and failure keeps enough professional cautiousness and professional skepticism. Let see the reasons in details as follows; The flaw of accounting system The American accounting system is rule-based unlike principle-based accounting standard is not easily evaded by Business Management and Organization Design that enterprise plans meticulously.8 The independence of auditor is not enough The independence is the key to ensure audit quality, and makes public believe accounting firm. The auditor providing management consultant service and in turn audit the same corporation impaired their independence. In 2001, WorldCom Inc. paid Arthur Andersen service expense about 16.8 million dollars, including audit expense 4.4 million dollars, tax consultant service 7.6 million dollars, non-financial statements audit 1.6 million dollars, other consultation 3.2 million dollars. Enron Corp. paid Arthur Andersen audit expense 25 million dollars, consultations and other service expense 27 million dollars, and the total added up to 52 million dollars. 8 Problem of control model The control includes three models: self-control, government control and independent control. Different models had different effects. The independence of self-control is the lowest, independent control is the reverse. The audit failure by Arthur Andersen makes public examines again the control system. Its no doubt that the self-control model plays an important role in improving the CPA profession. 8

Leveraging expertise Arthur Andersen had 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. The experts

Zhao, S. & Hua, L. 2006, Study of American Audit Failure, Modern Accounting and Auditing, http://www.accountant.org.cn/doc/acc200606/acc20060612.pdf (December 14, 2010)

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and their support systems were used to support marketing the firm instead of ensuring the highest quality accounting. Experts, expert systems and technology without access to managerial power to prevail can result in the same decisions that would be made in the absence of such expertise.9 Mark to market This method was for booking the value of its traders and used Special purpose entities (SPE). They were entities designed to function for special purpose. It was not directly disclosed, the use of Special purpose entities (SPE) to borrow from bank for company. The company through SPE record loan as cash generated from operation, as a result they were able to understate the company liabilities and overstate equity and profit thereby hiding the financial position of company investors.10

5.0

WHAT WOULD HAVE BEEN DONE BY AUDITORS

Auditing standards have a role to play in ensuring that factors such as objectivity, integrity and independence, factors which are essentially in the external auditors performance of his responsibilities are respected. The auditors provision of management consultant should not have been there, and should be limited, this reduces the level of technical expertise within firms and therefore their competence to conduct audits is decreased. The rotation of audit firm would strengthen the audit work and hence reduce the relationship with management and the level of being corrupted by client due to vulnerability.

Salterio, S. Enron: Accounting expertise to the rescue, http://cogsci.uwaterloo.ca/courses/Enron%20and%20expertise.ppt (December 20, 2010) 10 Saganga, Mussa (2010) Creative Accounting: Its essence, rationalization and eccentricity The accountant, Vol. 25, no. 4 pp 19.
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The financial audit remains an important aspect of corporate governance that makes management accountable to shareholders for its stewardship of a company. In this regard, attention is drawn to the importance of audit committees. Audit committees do not only serve as internal monitoring devices which support good corporate governance, they are also considered to be mechanisms of ensuring that an appropriate relationship exists between the auditor and the management whose financial statements are being audited. The external auditors responsibilities and the audit committees role in corporate governance are fundamental complements in helping to achieve the desired aims of corporate governance. Safeguards are necessary to ensure that the external auditors expertise is maximized. Even though external auditors play a vital role in corporate governance, through their involvement and their examination of financial statement and accounting policies several areas continue to give rise to problems 2

6.0

CONCLUSION AND RECOMMENDATION

The financial audit remains an important aspect of corporate governance that makes management accountable to shareholders for its stewardship of a company. In this regard attention is drawn to the importance of audit committees. Audit committees do not only serve as internal monitoring devices which support good corporate governance, they are also considered to be mechanisms of ensuring that an appropriate relationship exists between the auditor and the management whose financial statements are being audited. External auditors can impact the risk taking incentives of management through an appropriate application of accounting policies. The external auditors responsibilities and the audit committees role in corporate governance are fundamental complements in helping to achieve the desired aims of corporate governance311 The failures of corporate remain on two aspects that requiring reform, which are the audit function and the current financial reporting model.

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http://mpra.ub.uni-muenchen.de/15989/1/MPRA_paper_15989.pdf (accessed on December 21, 2010) 3 Stephen Bartholomeusz, After Enron: The new reform, http://www.austlii.edu.au/au/journals/UNSWLJ/2002/33.txt/cgi.../2002/33.rtf (December 16, 2010)

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The essence of corporate governance is a vital tool that needs to be respected for the existence of any company. The case Enron and WorldCom will forever remain as a huge lesson for the development of corporate governance and its implication Tanzania.

BIBLIOGRAPHY
1.

Victor Gaines, the Role of Corporate Governance in the Financial Institution Industry, http://www.theiia.org/download.cfm? file=28127(accessed on December 21, 2010) http://mpra.ub.unimuenchen.de/15989/1/MPRA_paper_15989.pdf (accessed on December 21, 2010) Stephen Bartholomeusz, After Enron: The new reform, http://www.austlii.edu.au/au/journals/UNSWLJ/2002/33.txt/cgi.../2 002/33.rtf (December 16, 2010) Peter Grosvenor Munzig, Enron and the Economics of Corporate Governance,http://www.economics.stanford.edu/files/Theses/The ses_2003/Munzig.pd (December 14,2010)

2.

3.

4.

5. http://www.cem.ulaval.ca/pdf/gershon_alhassan.pdf (December 17, 2010) 6. Gopinath. C, Corporate governance failure at Enron http://www.thehindubusinessline.com/2002/03/04/stories/200203 0400110900.htm (December 22, 2010) 7. Breeden, Richard C., Restoring trust, http://news.findlaw.com/hdocs/docs/worldcom/corpgov82603rpt. pdf ( December 22, 2010) 8. Zhao, S. & Hua, L. 2006, Study of American Audit Failure, Modern Accounting and Auditing, http://www.accountant.org.cn/doc/acc200606/acc20060612.pdf (December 14, 2010)
9.

Salterio, S. Enron: Accounting expertise to the rescue, http://cogsci.uwaterloo.ca/courses/Enron%20and %20expertise.ppt (December 20, 2010) 13

10. Saganga, Mussa (2010) Creative Accounting: its essence, rationalization and eccentricity The accountant, Vol. 25, no. 4 pp.19.

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