ACCT 572 Enron and Arthur Andersen

1. In analyzing this case take a “lessons learned” approach. Do not rehash the details of the Enron collapse and how it happened. Instead, concentrate on how the fraud could have been discovered earlier or prevented. Support your presentation with appropriate references and present your case using the following structure.
Define the problem(s) – (problems cause symptoms – e.g., stress causes the symptom of high blood pressure – often, the symptoms are directly described in the case, whereas the problem(s) usually are not – if necessary, indicate how the problems are related to one another) – make this section brief and succinct.

The fraud should have been discovered via a number of means.

In the very beginning, the government should have seen red flags when Enron and other corporations wanted the deregulation of the energy business. Since the government lifted the restrictions, they should have had some monitoring practices in places to monitor how these agencies were handling matters after the deregulation occurred. The government should have created governmental regulations, that would look into the practices of Enron and other companies like Enron from the very beginning.

There were many problems in the Enron case. First, when the gas bank was created, they should have thought twice about this since many of the natural gas producers needed cash, which Enron did not have. This would lead to problems for Enron. Second, Enron created SPE’s which caused more problems because they were providing money and keeping the money off the books so that investors could not see what was actually going on. These SPE’s only complicated issues for Enron and its investors.

If the government had appropriate regulations in place, as they have now, the fraud into the SPE’s could have been detected. The FASB seeks to “prohibit an entity from being a QSPE if a company that transfers assets to the entity enters into a commitment (such as a financial guarantee, liquidity commitment or total return swap) to provide additional cash or other assets to fulfill the QSPE’s obligations to its beneficial interest holders. Second, if an entity can reissue beneficial interests, the proposed Statement would prohibit that entity from being a QSPE if any party involved with the entity has certain risks or combination of risks and decision-making abilities. Third, the proposed Statement would prohibit an entity from being a QSPE if it holds equity instruments, such as shares or partnership interests. Finally, the proposed Statement would clarify certain of the requirements in Statement 140 related to legally isolating assets and surrendering control of assets”. Source: http://www.fasb.org/news/nr061003.shtml.
If these regulations were in place when Enron was creating their SPE’s then much of the fraud could have been prevented.

1. What important internal controls were ignored when LJM1 was created?

The internal controls that were ignored when LJM1 was created were first, any SPE that was created must have a certain percentage of equity owned by outside investors. The LJM1 failed to do that. Second, LJM’s books were kept separate from Enron’s. The accounting firm, Arthur Andersen should not have allowed LJM’s financial statements to go unconsolidated. Third, Enron allowed Fastow to sit on the Board of Directors of LJM1, which was a violation of their Code of Conduct. Fourth, Fastow used Enron stock as its capital to sell the Rhythms stock. This is a clear violation as it created a scenario where Enron was basically insuring itself, and therefore, without insurance.

2. How might Enron’s harsh Performance Review Committee (PRC) have aided company executives in committing the fraud?

Enron’s harsh performance review could have significantly aided their company. The performance review was so strict that if someone was not performing in a given period of time, they would indicate a poor rating to that employee and fire them. This caused employees to be at the top of their game if they expected to remain an employee. Such strict guidelines could have ensured that Enron employees followed all government guidelines and any Code of Ethics that Enron had in place.

3. The fraud at Enron is one of many major financial statement frauds that occurred in recent years (Qwest, Global Crossing, WorldCom, etc.). What are some factors that could explain why the falsifying of financial statements is occurring so frequently?

The falsifying of financial statements occurs so frequently because it is easy to do. Companies find ways around inputting the correct financial information. Furthermore, auditors and other governmental agencies have so many companies that they must examine, that it is hard for them to pay attention to the details of each company.

“Financial statement frauds are caused by a number of factors occurring at the same time, the most significant of which is the pressure on upper management to show earnings. Preparing false financial statements is made easier by the subjective nature of the way books and records are kept. The accounting profession has long recognized that, to a large extent, accounting is a somewhat arbitrary process, subject to judgment. The profession also indirectly recognizes that numbers are subject to manipulation. After all, a debit on a company’s books can be recorded as either an expense or an asset. A credit can be a liability or equity. Therefore, there can be tremendous temptation-when a strong earnings showing is needed-to classify those expenses as assets, and those liabilities as equity”. Source: http://kutenk2000.blogspot.com/2009/02/accounting-and-financial-statement.html

4. Suppose you are a certified fraud examiner but enjoy investing in the stock market as an additional source of income. Upon research of Enron’s stock, you notice that although its stock has a history of strong growth and a seemingly promising future, Enron’s financial reports are unclear and, frankly, confusing. In fact, you can’t even explain how Enron is making money. Could this lack of clarity in its financial reporting serve as a red flag in alerting you to the possibility of fraud at Enron? Why or why not?

The fact that Enron’s financial reports should definitely serve as a red flag. (****Again, I do not know anything about the duties of a fraud examiner. You will need to add into this section). “In 2000, Enron produced $1.22 billion of owner earnings-the first positive year in four. Using pure speculation (I hate to do it, but I will), let’s assume that Enron would have grown 15% a year for the next ten years, and then slowed to 5%. Sure, there’s no basis for our reasoning, but let’s forge ahead. Using the above assumptions, Enron would have been worth $60 a share using a 9% discount rate. With a 50% margin of safety, we couldn’t buy Enron for more than $30 a share, and certainly not at $90. By the time Enron dropped below $30, the reports of scandal were coming in. If you can’t trust the financial statements, you can’t own the business-and you would have gotten out as fast as you had jumped in”. Source: http://www.fwallstreet.com/article/54-enron-accounting-scandal-or-bad-business

1. How could the auditors, Arthur Andersen in this case, have performed their audits and not caught the Enron fraud? Is it possible for a financial statement auditor to form a GAAS-compliant audit and not catch major financial statement fraud? Has GAAS auditing changed enough since Enron to guarantee that all frauds are caught?

In an audit, it is possible that not all documents were provided to Arthur Anderson. It is possible that Anderson only reviewed the documents that they were given, and no fraud was found in those documents. “Fraud schemes are crafted to purposely exploit the accounting system and controls, and therefore it is more difficult for an auditor to find them. Since auditors are not all-knowing beings, the assurance that the financial statements are correct can only be “reasonable” assurance and not total assurance”. Source: http://www.sequenceinc.com/index.php?option=com_content&view=article&id=119. It is not the fault of Anderson to find fraud when they are not provided all pertinent information and documents.

I think it is possible for an auditor, from what I have read, to make a complaint but not catch fraud. An auditor can only attempt to mitigate any risk. They cannot fully prevent all fraudulent acts. “The client sometimes fails to acknowledge that the auditors clearly outline their audit and review responsibilities with engagement letters. Those letters usually state that the auditors provide reasonable assurance that they will detect material misstatements, but not absolute assurance”. Source: http://www.sequenceinc.com/index.php?option=com_content&view=article&id=119

I think that GAAS auditing has changed sufficient to ensure that many frauds are detected. I think that it is probably impossible to prevent all fraud, even with the standards in place. The government has created SOX to ensure that auditing firms are doing everything that they should to detect fraud.

2. What other solutions have been, or might be, implemented to detect and or prevent a future “Enron type” scenario?

Other solutions that could be implemented to detect fraud include the fact that a corporate board of directors needs to be in place. “A corporate board of directors is the major protection against a recurrence of an Enron-type catastrophe. SOX has given the board and the company officers this responsibility”. How can SOX prevent future Enrons? The main way is through the empowerment that it gives the audit committee and how it defines membership eligibility on this committee. First of all, SOX gives the audit committee quite specific responsibilities such as the integrity of a company’s financial statements, legal and regulatory compliance, and the vetting of independent auditors. These three SOX requisites for the audit committee give it quite a bit of clout. Also, SOX wants a minimum of three people as audit committee members, all of whom must be “independent.” That is, they cannot be members of the management team. These members must also be “financially literate” with at least one member who is a “financial expert” as defined by SOX. Though there have been many complaints about SOX, it is really conceptually quite sound. Just recently, the SEC made some moves to lessen the severity of SOX, especially for smaller corporations. Consequently, I believe that the SOX detractors will be diminishing. SOX has done a great deal to reduce the possibility of another Enron. However, the fact remains that, human nature being what it is, there will be future financial scandals, but probably with far less impact than the Enron scandal”. Source: http://www.ecommercetimes.com/story/55489.html?wlc=1304956143

Stockholders should also get more involved in the companies that they invest in. They need to pay close attention to where the money is going. They should attend annual meetings and question any transactions. Their money is the money that is being invested, they should have some say so.

I hope the information I have provided is helpful. Thank you for using Brain Mass and best of luck in your future studies. Have a wonderful day! Karen Coleman