Pre-Final in Internal Auditing

THE COLLAPSE OF ENRON

CORPORATION (USA) (2001)

Submitted by:

Kathlyn Joy L. Salazar

Submitted to:

Ms. Roma Salvador

BSAT-IV
 The Collapse OF Enron Corporation (USA) (2001)
The collapse of US energy company Enron, which directly initiated the fall of its auditor Arthur Andersen
(AA)2, not only lead to the stock market crash but also brought the accounting and auditing profession into great
disrepute. Before its bankruptcy filing in December 2001, Enron was widely regarded as one of the most innovative,
fastest growing, and managed businesses in the United States. Enron Corporation based in Houston, Texas, was
created in 1985 by Kenneth Lay as a result of the merger of Houston Natural Gas and Inter North. 1989 onwards
Enron began trading in commodities, buying and selling wholesale contracts in energy. In 2000, Enron's position on
the Fortune 5003 list of the US's big companies was at an enviable seven The turnover grew at a fast pace, growing
from 40 billion US dollar in 1999 to 101 billion US dollar in 2000, with most of the new income coming from
broking energy commodities (Satheesh Kumar, 2010). The company's business was to sell natural gas and electricity,
deliver energy and other commodities such as bandwidth internet connection, and provide risk management and
financial services to the clients around the world. Its natural gas pipeline business proved to be a grand success. The
company then introduced trading in derivative contracts based on prices of oil, gas, electricity and other variables,
and soon this derivative trading became its core business. The company's earnings soared and its share prices also
sky rocketed. The reported annual revenues of the company grew from about $10 billion in the early 1990s to $101
billion in 2000, ranking it seventh on the Fortune 5003 Enron's shares were then selling at $90 per unit, which placed
company's market value at $700 billion. In just 15 years, Enron grew from nowhere to be one of America's largest
companies, employing 21,000 staff in more than 40 countries. But the fortune did not last long. The company's
success soon turned out to be an elaborate scam. Trouble actually began in August 2001 when the Enron CEO
resigned for undisclosed reasons. The company reported its first quarterly loss in 4 years taking a charge against
earnings of $1 billion for poorly performing businesses. The reported third quarter loss was $618 million. On
November 8, the company announced in a SEC filing that it was restating its earnings since 1997 — reducing them
by $586 million. The news that the company had previously inflated its profits produced a disastrous effect on the
share price. As share price collapsed (Enron's stock was valued at $90 per share at the beginning of 2001 and it is
worth almost nothing at the end of the same year) bond rating agencies downgraded Enron's debt to below-
investment-grade, or junk bond status. In December 2001, the company filed for bankruptcy protection in the biggest
case of bankruptcy in the US up to that point. The US Department of Justice, the SEC, the market regulator and
various congressional committees probed the wrongdoings of Enron. The Enron collapse harmed not only its
investors but also thousands of its workers who lost their jobs and retirement packages. It is estimated that Enron
den•ñse caused a loss of about $80 billion in market capitalization to investors, including sophisticated financial
institutions and employees (Nguyen, 2008).

The Causes of Enron’s Bankruptcy

Truthfulness

The lack of truthfulness by management about the health of the company, according to Kirk Hanson, the
executive director of the Markkula Center for Applied Ethics. The senior executives believed Enron had to be the
best at everything it did and that they had to protect their reputations and their compensation as the most successful
executives in the U.S.

The duty that is owed is one of good faith and full disclosure. There is no evidence that when Enron’s CEO
told the employees that the stock would probably rise that he also disclosed that he was selling stock. Moreover, the
employees would not have learned of the stock sale within days or weeks, as is ordinarily the case. Only the
investigation surrounding Enron’s bankruptcy enabled shareholders to learn of the CEO stock sell-off before
February 14, 2002 which is when the sell-off would otherwise have been disclosed. Why the delay? The stock was
sold to the company to repay money that the CEO owed Enron—and the sale of company stock qualifies as an
exception under the ordinary director and officer disclosure requirement. It does not have to be reported until 45
days after the end of the company’s fiscal year. (The Conference Board, Inc., 845)
Interest
It has been suggested that conflicts of interest and a lack of independent oversight of management by Enron's
board contributed to the firm's collapse. Moreover, some have suggested that Enron's compensation policies
engendered a myopic focus on earnings growth and stock price. In addition, recent regulatory changes have focused
on enhancing the accounting for SPEs and strengthening internal accounting and control systems. We review these
issues, beginning with Enron's board. (Gillan SL, Martin JD, 2007)

The conflict of interest between the two roles played by Arthur Andersen, as auditor but also as consultant
to Enron. While investigations continue, Enron has sought to salvage its business by spinning off various assets. It has
filed for Chapter 11 bankruptcy, allowing it to reorganize while protected from creditors. Former chief executive and
chairman Kenneth Lay has resigned, and restructuring expert Stephen Cooper has been brought in as interim chief
executive. Enron's core business, the energy trading arm, has been tied up in a complex deal with UBS Warburg. The
bank has not paid for the trading unit, but will share some of the profits with Enron.

Enron and the reputation of Arthur Andersen

The revelation of accounting irregularities at Enron in the third quarter of 2001 caused regulators and the
media to focus extensive attention on Andersen. The magnitude of the alleged accounting errors, combined with
Andersen's role as Enron's auditor and the widespread media attention, provide a seemingly powerful setting to
explore the impact of auditor reputation on client market prices around an audit failure. CP investigates the share
price reaction of Andersen's clients to various information events that could lead investors to revise their beliefs
regarding Andersen's reputation. (Nelson KK, Price RA, Rountree BR, 2008)

Perhaps most damaging to Andersen's reputation was their admission on January 10, 2002 that employees
of the firm had destroyed documents and correspondence related to the Enron engagement. For a sample of S&P
1500 firms, CP reports that in the 3-day window following the shredding announcement (0, +2), Andersen clients
experienced a significant −2.03% market reaction, and this reaction was significantly more negative than for Big 4
clients. Andersen's Houston office clients, where Enron was headquartered, experienced an even stronger negative
market reaction than Andersen's non-Houston clients.2 Overall, CP concludes the shredding announcement had a
significant impact on the perceived quality of Andersen's audits, and that the resulting loss of reputation had a
negative effect on the market values of the firm's other clients.

In this study, we report new findings that shed light on whether this event study evidence is consistent with
an auditor reputation effect. In so doing, we do not suggest that auditor reputation does not matter. As discussed
above, there is ample evidence that reputation is important to auditors and their clients. Rather, our purpose is to
determine whether client returns around Andersen's shredding announcement and related events can be considered
evidence of a reputation effect, or whether the results are confounded by other effects. 2.4 An important factor:
accounting fraud (using “mark to market” and SPE as tools)

Mark to Market
As a public company, Enron was subject to external sources of governance including market pressures,
oversight by government regulators, and oversight by private entities including auditors, equity analysts, and credit
rating agencies. In this section we recap the key external governance mechanisms, with emphasis on the role of
external auditors. This method requires that once a long-term contract was signed, the amount of which the asset
theoretically will sell on the future market is reported on the current financial statement.

In order to keep appeasing the investors to create a consistent profiting situation in the company, Enron
traders were pressured to forecast high future cash flows and low discount rate on the long-term contract with Enron.
The difference between the calculated net present value and the originally paid value was regarded as the profit of
Enron. In fact, the net present value reported by Enron might not happen during the future years of the long-term
contract. There is no doubt that the projection of the long-term income is overly optimistic and inflated.
Special Purpose Entity
Accounting rule allow a company to exclude a SPE from its own financial statements if an independent
party has control of the SPE, and if this independent party owns at least 3 percent of the SPE. Enron need to find a
way to hide the debt since high debt levels would lower the investment grade and trigger

Using the Enron’s stock as collateral, the SPE, which was headed by the CFO, Fastow, borrowed large sums
of money. And this money was used to balance Enron’s overvalued contracts. Thus, the SPE enable the Enron to
convert loans and assets burdened with debt obligations into income. In addition, the taking over by the SPE made
Enron transferred more stock to SPE.
However, the debt and assets purchased by the SPE, which was actually burdened with large amount of debts, were
not reported on Enron’s financial report. The shareholders were then misled that debt was not increasing and the
revenue was even increasing.

Fraudulent Accounting at Enron

Enron adopted fraudulent accounting practices and its audit firm AA, which was being paid huge audit and
non-audit fees, collaborated in that exercise. Enron used to adopt questionable accounting and reporting practices
over a long period of time. But its auditor AA, failed to detect Enron's frauds. Enron broke up after revelations of
AA's performance as statutory auditor. The Powers Committee, appointed by the Enron's Board to look into the
firm's accounting in October 2001, observes: "The evidence available to us suggests that Andersen did not fulfil its
professional responsibilities in connection with its audits of Enron's financial statements, or its obligation to bring to
the attention of Enron's Board (or the Audit and Compliance Committee) concerns about Enron's internal contracts
over the related-party transactions"4. Benston et al. (2003) observe on Powers Report of 2002 and identified five
types of failures that are most noteworthy: first, Enron's failure to account properly for and disclose investments in
special purpose entities (SPEs), Enron's contingent liability for their debt, and Enron's dealings with them; second,
Enron's incorrect recognition of revenue that increased its reported net income; third, restatements of merchant
investments using fair-value accounting based on unreliable information to overstate both assets and net income of
merchant investments; fourth, Enron's incorrect accounting for its own stock that was issued to and held by SPEs;
and fifth, inadequate disclosure of and accounting for related-party transactions, conflicts of interest, and their costs
to stockholders.

Investigations have revealed that the company used to book projected profits immediately after building an
asset, such as a power plant, without waiting for their realization. If the revenue from the asset was less than the
projected amount, instead of taking the loss, the company would then transfer these assets to an off-the-books firm,
where the loss would go unreported. The company also adopted "the mark-to-market" practice to hide losses and
make the company appear to be more profitable than it really was. In order to cope with the mounting losses, the
company often used special purpose entities (SPEs) in a creative way 5 . It used SPEs to hide any assets that were
losing money or business ventures that had gone unprofitable. In this way it used to keep impaired assets off of the
company's books. In return, the company would issue to the investors of the SPE shares of Enron's common stock
to compensate them for the losses. Much of the revenue that Enron was reporting during these years did not represent
any actual money generated from operations. Instead, it came from investors. A major part of the reported revenue
was the product of accounting manipulations orchestrated by the company's Chief Finance Officer, Andrew Fastow.
In fact, whatever money that was paid out as dividend to shareholders came from the investors themselves and not
from profitable gas and energy trading transactions.

Subsequent investigations have revealed several circumstances that made it possible for Enron to succeed
in deceiving the public. There was connivance with external auditors and banks. The SEC exempted Enron from
investment laws and Enron took its full advantage. The issue which has particularly shocked many is the unholy
nexus between Enron and its external auditor Arthur Andersen. Andersen has been Enron auditor for over a long
duration (about 20 years). It provided both external and internal audit services for several years. And that enabled it
to generate a very large amount of fee from the company. In 2000, Arthur Andersen earned $25 million in audit fees
and $27 million in consulting fees, which accounted for roughly 27% of the audit fees of public clients for Arthur
Andersen's Houston office. Such was the nexus between the two parties that Andersen even opened a permanent
office space in Enron's buildings. Andersen knew it clearly that there were serious problems with Enron's financial
statements, but it overlooked those problems and signed the statements off. On June 15 2002Arthur Andersen was
charged with and found guilty of obstruction of justice for shredding the thousands of documents related to its audit
of Enron and deleting e-mails and company files that tied the firm to its audit of Enron. The firm was effectively put
out of business. Since the US SEC does not allow convicted felons to audit public companies, the firm agreed to
surrender its CPA license and its right to practice before the SEC on August 31 2002, effectively putting the firm out
of business, and 28000 employees in the US and 85,000 employees worldwide lost their jobs. The damage to the
firm's name has been so great that it is difficult for it to return as a viable business even on a limited scale. There
were over 100 civil suits pending against the firm related to its audits of Enron and other companies. The firm sold
most of its American operations to KPMG, D&T, E&Y, and GT. Enron is not an isolated case. There have been
many other audit failure cases involving AA. Examples include WorldCom, Waste Management, the Baptist
Foundation of Arizona, and Sunbeam. However, Enron is the worst case of corporate obstruction that has ever been
seen. As a consequence of the Enron scandal, several new regulations and legislations have been enacted to bring
about greater sparency in corporate financial reporting. This has happened not only in the United States but also in
many other countries throughout the world.

Prisoner’s Dilemma Shown in Enron’s Case

At the time of the firm's collapse, Enron was engaged in a wide range of activities including energy
production and the trading of energy-related commodities and derivatives. As such, many of its activities were
potentially subject to oversight by the Commodities and Futures Trading Commission (CFTC) or the Federal Energy
Regulatory Commission (FERC). The CFTC's primary mission is to ensure that the commodity futures and options
markets operate in an open and competitive manner, while the FERC regulates the interstate transmission and market
for energy products. Of course, the primary source of federal oversight for publicly traded firms is the Securities and
Exchange Commission (SEC). We discuss each of these in turn.

In the zero-sum game, each party is trying to secure more gains for themselves even if the best outcome is
cooperating with each other. Obviously, to pursue maximum profits, wrong doings like accounting fraud will harm
the shareholders’ interests. Arthur Andersen, as auditor but also as consultant to Enron, has to be responsible for both
managers and shareholders since the provided accounting information has a direct influence on economic benefits of
both parties. Clearly, the managers and Arthur Andersen chose betraying the shareholders to maximize their self-
interests.
DID ENRON CORPORATION SUCCESSFULLY IMPLEMENT GOOD CORPORATE
GOVERNANCE OR NOT?

Enron Corporation did not successfully implement good corporate governance because of the following
reasons:

(1) There should be a healthy corporate culture in a company. In Enron’s case, its corporate culture played an
important role of its collapse. The senior executives believed Enron had to be the best at everything it did and
the shareholders of the board, who were not involved in this scandal, were over optimistic about Enron’s
operating conditions. When there existed failures and losses in their company performance, what they did was
covering up their losses in order to protect their reputations instead of trying to do something to make it correct.
The “to-good-to-be-true” should be paid more attention by directors of board in a company.

(2) A more complete system is needed for owners of a company to supervise the executives and operators and then
get the idea of the company’s operating situation. There is no doubt that more governance from the board may
keep Enron from falling to bankruptcy. The boards of directors should pay closer attention on the behavior of
management and the way of making money. In addition, Enron’s fall also had strikingly bad influence on the
whole U.S. economy. Maybe the government also should make better regulations or rules in the economy.

(3) “Mark to market” is a plan that Jeffrey Skilling and Andrew Fastow proposed to pump the stock price, cover
the loss and attract more investment. But it is impossible to gain in a long-term operation in this way, and so it
is clearly immoral and illegal. However, it was reported that the then US Security and Exchange Commission
allowed them to use “mark to market” accounting method. The ignorance of the drawbacks of this accounting
method by SEC also caused the final scandal. Thus, an accounting system which can disclose more financial
information should be created as soon as possible.

(4) Maybe business ethics is the most thesis point people doing business should focus on. As a loyal agent of the
employer, the manager has a duty to serve the employer in whatever ways will advance the employer's self-
interest. In this case, they violated the principle to be loyal to the agency of their ENRON. Especially for
accountants, keeping a financial statement disclosed with true profits and losses information is the basic
responsibility that they should follow.

As corporate acts originate in the choices and actions of human individuals, it is these individuals who must be
seen as the primary bearers of moral duties and moral responsibility. Then the chairman of the board, Kenneth Lay,
and CEO, Jeffrey Skilling, to allowed the CFO, Andrew Fastow, to build private cooperate institution secretly and
then transferred the property illegally. The CFO, Andrew Fastow, violated his professional ethics and took the crime
of malfeasance. When the superior, the chairman of the board of Kenneth Lay and CEO Jeffrey Skilling, ordered
conspiratorial employees to carry out an act that both of them knowing is wrong, these employees are also morally
responsible for the act.

The courts will determine the facts but regardless of the legal outcome, Enron senior management gets a failing
grade on truth and disclosure. The purpose of ethics is to enable recognition of how a particular situation will be
perceived. At a certain level, it hardly matters what the courts decide. Enron is bankrupt—which is what happened
to the company and its officers before a single day in court. But no company engaging in similar practices can derive
encouragement for any suits that might be terminated in Enron’s favor. The damage to company reputation through
a negative perception of corporate ethics has already been done. Arthur Andersen violated its industry specifications
as a famous certified public accountant.

The acts of a corporation's managers are attributed to the corporation so long as the managers act within their
authority. However, the shareholders of Enron didn't know and realize this matter from the superficial high stock
price. Therefore, the whole corporation was not of responsibility for this scandal. Actually, if the board and other
shareholders paid more attention to those decisions made by the chief, CEO, CFO and those relevant staffs, ENRON
can avoid this result.
CREDIT SUISSE FIRST BOSTON (CSFB) 2002
Pre-Final in Internal Auditing

Submitted by:

Ivy B. Mondejar

Submitted to:

Ms. Roma Salvador

BSAT-IV