Business Fraud

(The Enron Problem)

W. Steve Albrecht
Ph.D., CPA, CIA, CFE
Brigham Young University
2003 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 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 peopleas
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 beforenow a
course on many college campuses
2003 by the AICPA

A recent fraud where I testified

Large Fraud of $2.6
Billion over 9 years

Year 1
Year 3
Year 5
Year 7
Year 9

$600K
$4 million
$80 million
$600 million
$2.6 billion

In years 8 and 9, four of

the worlds largest banks
were involved and lost
over $500 million
2003 by the AICPA

Why Fraud is a Costly Business

Problem
Fraud Losses Reduce
Net Income $ for $
If Profit Margin is 10%,
Revenues Must Increase
by 10 times Losses to
Recover Affect on Net
Income
Losses. $1 Million
Revenue.$1 Billion

2003 by the AICPA

Fraud Robs Income

Revenues
Expenses
Net Income
Fraud
Remaining

$100
90
$ 10
1
$ 9

100%
90%
10%

To restore income to $10, need

$10 more dollars of revenue to
generate $1 more dollar of
income.

Fraud Cost.Two Examples

General Motors

$436 Million Fraud

Profit Margin = 10%
$4.36 Billion in
Revenues Needed
At $20,000 per Car,
218,000 Cars

2003 by the AICPA

Bank

$100 Million Fraud

Profit Margin = 10 %
$1 Billion in Revenues
Needed
At $100 per year per
Checking Account,
10 Million New
Accounts

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

2003 by the AICPA

$2 billion drop in
stock value

Fraud Internationally
Transparency Intl
1. Denmark
2. Finland
3. Sweden
4. New Zealand
5.Iceland
6. Canada
7. Singapore
8. Netherlands, Norway

2003 by the AICPA

16.
17.
25.
29.
43.
52.
81.
84.
85.

Hong Kong
United States
Austria
Japan
Taiwan
South Korea
China
Nigeria
Paraguay
Cameroon

Types of Fraud
Fraudulent Financial
Statements
Employee Fraud
Vendor Fraud
Customer Fraud
Investment Scams
Bankruptcy Frauds
Miscellaneous Frauds
2003 by the AICPA

The common element

is deceit or trickery!

Recent Financial Statement

Frauds
Enron
WorldCom
Adelphia
Global Crossing
Xerox
Qwest
Many others (Cendant, Lincoln Savings, ESM,
Anicom, Waste Management, Sunbeam, etc.)
2003 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), Denis 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 by the AICPA

Largest Bankruptcy Filings

(1980 to Present)

Company
1. WorldCom
2. Enron
3. Texaco
4. Financial Corp of America
5. Global Crossing
6. Adelphia
7. PG&E
8. MCorp
9. Kmart
10. NTL
2003 by the AICPA

Assets (Billions) When Filed

$101.9
July, 2002
$63.4
Dec., 2001
$35.9
$33.9

April, 1987
Sept., 1988

$25.5
$24.4

Jan., 2002
June, 2002

$21.5
$20.2

April, 2001
March, 1989

$17.0
$16.8

Jan., 2002
May, 2002

Why so many financial statement

frauds all of a sudden?
Good economy was masking many problems
Moral decay in society
Executive incentives
Wall Street expectationsrewards for short-term
behavior
Nature of accounting rules
Behavior of CPA firms
Greed by investment banks, commercial banks,
and investors
Educator failures
2003 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 resultbuy; if not, buy
anyway

2003 by the AICPA

Moral Decay
Attendees at the April, 1998 Business Week Forum of Chief Financial Officers
revealed:
67% of CFOs said they had been asked by senior company executives to
misrepresent corporate financial results
12% of CFOs admitted they had actually misrepresented financial results
55% said they had fought off requests to cook the books
Honesty studies
1961: 12%
1986: 31%
2002: ???
Modeling & Labeling
More dishonest modeling (examples)
Less labeling (teaching & training)(10 hrs. per week less time)

2003 by the AICPA

Executive Incentives
Meeting Wall Streets Expectations
Stock prices are tied to meeting Wall Streets 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 optionsfar exceeds
compensation (tied to stock price)
Performance is based on earnings & stock price
2003 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 by the AICPA

Complaint in Fraud CaseExpert

Witness
Several hundred million in earnings overstatement
Complaint: The goal of this scheme was to ensure that
(the company) always met Wall Streets growing
earnings expectations for the company. (The
companys) management knew that meeting or
exceeding these estimates was a key factor for the stock
price of all publicly traded companies and therefore set
out to ensure that the company met Wall Streets targets
every quarter regardless of the companys actual
earnings. During the period ___ to ___alone,
management improperly inflated the companys
operating income by more than $500 million before
taxes, which represents more than one-third of the total
operating income reported by (the company.)
2003 by the AICPA

Complaint in Fraud Case

Expert Witness
The participants in the illegal scheme
included virtually the entire senior
management of (the company), including
but not limited to its former chairman and
chief executive officer, its former president,
two former chief financial officers and
various other senior accounting personnel.
In total, there were over 20 individuals
involved in the earnings overstatement
schemes.
2003 by the AICPA

Nature of Accounting Rules

In the U.S., accounting standards are rulesbased 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
cant do thisbecause it isnt GAAP
It is impossible to makes rules for every situation
2003 by the AICPA

Auditorsthe CPAs
Failed to accept responsibility for fraud detection (SEC,
Supreme Court, public expects them to detect fraud) If
auditors arent the watchdogs, then who is?
Became greedy--$500,000 per year per partner
compensation wasnt 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 by the AICPA

Educators
Havent taught ethics enough (cant
make up own rules to meet own needs
Need to teach students about fraudneed
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 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 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
Revenues
(Income Assets )
2003 by the AICPA

xxx
xxx

Revenue-Related Transactions and Frauds

Transaction

Accounts Involved

Fraud Schemes

1. Estimate all
uncollectible
accounts receivable
2. Sell goods and/or
services to
customers

Bad debt expense,

allowance for
doubtful accounts
Accounts receivable,
revenues (e.g. sales
revenue) (Note: cost
of goods sold part of
entryh is included in
Chapter 5)

1. Understate allowance for doubtful

accounts, thus overstating receivables

3. Accept returned
goods from
customers

Sales returns,
accounts receivable

4. Write off
receivables as
uncollectible

Allowance for
doubtful accounts,
accounts receivable

5. Collect cash after

discount period

Cash, accounts
receivable

6. Collect cash within Cash, sales

discount period
discounts, accounts
receivable
2003 by the AICPA

2. Record fictitious sales (related parties,

sham sales, sales with conditions,
consignment sales, etc.)
3. Recognize revenues too early (improper
cutoff, percentage of completion, etc.)
4. Overstate real sales (alter contracts,
inflate amounts, etc.)
5. Not record returned goods from
customers
6. Record returned goods after the end of
the period
7. Not write off uncollectible receivables
8. Write off uncollectible receivables in a
later period
9. Record bank transfers as cash received
from customers
10. Manipulate cash received from related
parties
11. Not recognize discounts given to
customers

Overstating Inventory
The second most common way to commit
financial statement fraud is to overstate
inventory.
Beginning Inventory
Purchases
Goods Available for sale
Ending Inventory
Cost of Goods Sold
Income
2003 by the AICPA

OK
OK
OK
High
Low
High

Inventory/Cost of Goods Sold Frauds

2003 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 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 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 by the AICPA

Detecting Financial Statement

Fraud
1. Management & Board

2. Relationships
With Others

Detecting Financial
Statement Fraud
3. Organization & Industry
2003 by the AICPA

4. Financial Results &

Operating Characteristics

Enron Fraud
Compared to other financial statement frauds, Enron
was a very complicated fraud. (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 didnt have to lie. All
they had to do was to obfuscate it with sheer complexity
although they probably lied too.
Senator John Dingell
2003 by the AICPA

Enrons 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 Bankto
buy and sell gas
2003 by the AICPA

Enrons History
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 began hiring the best and brightest traders and
rewarded them handsomelythey were allowed to eat
what they killed
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 by the AICPA

The Motivation
Enron delivered smoothly growing earnings (but not cash flows.) Wall
Street took Enron on its word but didnt understand its financial
statements.
It was all about the price of the stock. Enron was a trading company
and Wall Street normally doesnt reward volatile earnings of trading
companies. (Goldman Sacks is a trading company. Its stock price
was 20 times earnings while Enrons 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 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 by the AICPA

Enrons Corporate Strategy

Was devoid of any boundary system
Enrons core business was losing moneyshifted 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, Enrons derivatives-related assets increased from $2.2
billion to $12 billion and derivates-related liabilities increased from
$1.8 billion to $10.5 billion
Enrons 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 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. Enron was built to maximize
value by maximizing the individual parts.
Enron traders were afraid to go to the
bathroom because the guy sitting next to
them might use information off their screen
to trade against them.
Enron took more risk than othersit swung for the fences.
2003 by the AICPA

Enrons Arrogance
Those whom the Gods would destroy they first make
proud.
Enrons banner in lobby: Changed from The Worlds
Leading Energy Company to THE WORLDS LEADING
COMPANY
Older, stodgier companies will topple over from their own
weight
Skilling
Conference of Utility Executives in 2000: Were going to
eat your lunch.Jeff Skilling
2003 by the AICPA

Notable Events
Jeff Skilling left in Augustgave no reason for his

departure.
By mid-August 2001, the stock price began falling
Former CEO, Kenneth Lay, came back in August
Oct. 16announced $618 million loss but not that it had
written down equity by $1.2 billion
OctoberMoodys downgraded Enrons debt
Nov. 8Told investors they were restating earnings for
the past 4 and years
Dec. 2Filed bankruptcy

2003 by the AICPA

Executives Abandon Enron

Rebecca Mark-Jusbasche, formerly CEO of Azurix,

Enrons 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 Enrons Broadband services,
departed in August 2001.
Jeffrey Skilling, Enron CEO, left on August 14, 2001
2003 by the AICPA

Enrons revenues and income

Year

Revenues

Income

1997

$20.2 B

$105 M

Income
(Restated)*
$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 partnershipsmainly used to hide debt.
2003 by the AICPA

Value at Risk (VAR) Methodology

Enron captured 95% confidence intervals for one-day holding

periodsdidnt disclose worst case scenarios

Relied on professional judgment of experienced business and risk
managers to assess worst case scenarios
Investors didnt know how much risk Enron was taking
Enron had over 5,000 weather derivatives deals valued at over $4.5
billioncouldnt be valued without professional judgment
In 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 Managementthat
employed rocket Scientists and Nobel laureates to design
sophisticated computer models, Enrons statement that it would
refine its own models should have raised concerns

2003 by the AICPA

Special Purpose Entities (SPEs)

(Enrons principal method of financial statement fraud involved the use of SPEs
(Special Purpose Entities))

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 by the AICPA

Enrons 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 managementBlockbuster 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 and not put on financial
statements of Enron)
To manipulate cash flows, especially in 4 th quarters
Many SPE transactions were timed (or illegally backdated) just near end of quarters so that income could be
booked just in time and in amounts needed, to meet
investor expectations

2003 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%)
1984EITF 84-15 Grantor Trust Consolidations
(Permitted non-consolidation if owned more than 50%)
1990EITF 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 by the AICPA

Mark-to-Market Accounting
Marketable securities, derivatives and financial contracts are

required to be reported on the balance sheet at their current market

values (rather than original cost) (Implemented with FAS 115 in
1993 (securities with readily determinable market values) and FAS
133 (for derivatives, even those with no traded market values)
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 (even private) contracts
were signed based on net present value of all future estimated
revenues and costs.
Profits really tracked price of oil futuresalmost perfectly correlated

2003 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 partnershipJoint 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 percent was owned by
outsiders
2003 by the AICPA

LJM1 SPE
Responsible for 20% of SPE restatement or

$100 million
Should have been consolidatedan error in
judgment by Andersen (per Andersen)
After Andersens 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 publicinvolved
complex issues concerning the valuation of
various assets and liabilities.
2003 by the AICPA

Fastows Explanation of
Partnerships (SPEs)
The partnerships were used for

unbundling and reassembling the

various components of a contract. We
strip out price risk, we strip out interest
rate risk, he said. Whats left may not be
something that we want.

The obvious question is Why would

anyone want whatever was left?

2003 by the AICPA

Enrons Disclosures
SEC Regulation S-K requires description of

related-party transactions that exceed $60K and

an executive has a material interest
Included a footnote Related Party Transactions
to financial statements in Forms 10-Q and 10-K
beginning with second quarter of 1999 through
2nd quarter of 2001
A senior officer of Enron is managing member
of LJMs general partner. (Fastow)
2003 by the AICPA

Enrons FootnotesDisclosures of
Enron Partnership
Report

10QQ1 2000 Footnote 7

Filed with the

SEC
5/15/2000

10QQ2 2000 Footnote 8

8/14/2000

10QQ3 2000 Footnote 10

11/14/2000

10QQ1 2001 Footnote 8

5/15/2001

10QQ2 2001 Footnote 8

8/14/2001

10QQ3 2001 Footnote 4

11/19/2001

2003 by the AICPA

Footnote

The Famous Misleading Earnings

Release on October 16, 2001
Heading: Enron Reports Recurring Third Quarter

Earnings of $0.43 per diluted shares.

Projected recurring earnings for 2002 of $2.15
If you dug deep, you learned that Enron actually lost
$618 million or $0.84 per sharethey 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
shareholders equity, including what was described as a
$1 billion correction to an accounting error. (This was
learned a couple of days later.)
2003 by the AICPA

Who Discovered Enrons

Problems?
In early 2001, Jim Chanos, who runs Kynikos

Associates, a highly regarded firm specializing in

short selling said publicly that no one could
explain how Enron actually made money. He
noted that Enron had completed transactions
with related parties that were run by a senior
officer of Enron and assumed it was a conflict of
interest. (Enron wouldnt answer questions
about LJM and other partnerships.)

2003 by the AICPA

Fortune ArticleMarch 5, 2001

To skeptics, the lack of clarity raises a red flag about

Enrons pricey stockthe inability to get behind the

numbers combined with ever higher expectations for the
company may increase the chance of a nasty surprise.
Enron is an earnings-at-risk story
At the least, these sorts of hard-to-predict earnings are
usually assigned a lower multiple...In 1999 its cash flow
from operations fell from $1.6 billion the previous year to
$1.2 billion. In the first nine months of 2000, the
company generated just $100 million in cash. (In fact,
cash flow would have been negative if not for the $410
million in tax breaks it received from employees
exercising their options.
2003 by the AICPA

Enrons Cash Flows

Enrons cash flows bore little relationship to

earnings (a lot due to mark to market.) On

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 by the AICPA

Enrons Cash Flow Ratio

Negative Cash Flows: 1st three quarters in 1999, 1st three quarters in 2000,
1st two quarters in 2001.
2003 by the AICPA

Role of Andersen
Was paid $52 million in 2000, the majority of which was for non-audit

related consulting services.

Failed to spot many of Enrons losses
Should have assessed Enron managements internal controls on
derivates tradingexpressed approval of internal controls during 1998
through 2000
Kept a whole floor of auditors assigned at Enron year around
Enron was Andersens second largest client
Did both external and internal audits
CFOs and controllers were former Andersen executives
Accused of document destructionwas 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 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 by the AICPA

Role of Law Firms

Enrons outside law firm was paid

substantial fees and had previously

employed Enrons general counsel
Failed to correct or disclose problems
related to derivatives and special purpose
entities
Helped draft the legal documentation for
the SPEs
2003 by the AICPA

Role of Credit Rating Agencies

The three major credit rating agenciesMoodys,

Standard & Poors and Fitch/IBCAreceived substantial

fees from Enron
Just weeks prior to Enrons bankruptcy filingafter most
of the negative news was out and Enrons stock was
trading for $3 per shareall three agencies still gave
investment grade ratings to Enrons 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 by the AICPA

So Why Did Enron Happen?

Individual and collective greedcompany, its

employees, analysts, auditors, bankers, rating agencies

and investorsdidnt 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 practiceslack of transparency in
reporting financial affairs
Unduly aggressive earnings targets and management
bonuses based on meeting targets
Excessive interest in maintaining stock prices

2003 by the AICPA

Will there be another Enron?

Yes
The executives of many companies failed to sign off
on their financial statements
Recently, there have been many more financial
statement frauds than ever before
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 rotation; Oversight Board,

limitations on services, etc.)

Accountants are being much more careful

2003 by the AICPA