Case Study: the Arthur Anderson Enron Scandal

By Aditya V

Aniruddha M Thomas J

“The day Arthur Andersen loses the public's trust is the day we are out of business.”   -Steve Samek, Country Managing Partner, United States, on Andersen's Independence and Ethical Standards CD-Rom, 1999.

Arthur Andersen and Enron - the events leading up to and including the debacle of December 2001, when Enron filled for bankruptcy. 

How could the case have a positive influence in the accounting industry as a whole? 

Safety Measures in place prior to the events

History (Chronology of Events)

Changes in the accounting industry

Positive Nature of the Changes

Conclusion

  The safety measures included:

Generally Accepted Accounting Principles (GAAP),

Generally Accepted Auditing Standards (GAAS),

Statements on Auditing Standards (SAS), and all professional ethics. 

In spite of all of these safety measures the wrongdoings at Enron went undetected for a long period of time. 

The major problem was that of collusion. GAAP and GAAS can not prevent fraud when people work in collusion to perpetrate that fraud. 

Therefore, when events like these transpire, changes are required in an attempt to prevent similar occurrences.

Timeline of Events

•1996 -Arthur Andersen has an audit failure in Waste Management; Andersen paid a censure of $7 million.•1997 -Arthur Anderson has an audit failure in Sunbeam; Andersen paid $110 million to settle shareholder litigations.•January 1997- Jeffery Skilling is named president and COO of Enron. Skilling implements his assets are bad intellectual assets are good campaign to “clean up” Enron’s financial statements. Begins using the LJM partnerships run by Andrew Fastow, Enron’s CFO.•Early 2001- Jim Chanos takes note of Enron’s lack of money-making activities and begins to wonder about the LJM partnerships.•February 2001-Skilling’s promotion to CEO takes effect, he replaced Charles Lay.

June 2001- Enron executives sell shares as stocks slid 39% in the first quarter.

August 2001- Skilling quits for personal reasons, and Charles Lay is named CEO again.

Oct. 16 2001- Enron reports a third quarter loss of $618 million. They cite the loss as being partially due to the LJM partnerships.

Oct. 22 2001- SEC starts an investigation into the LJM partnerships, and CFO Fastow leaves Enron.

Nov. 8 2001- Enron’s Net income back through 1997 is revalued by $586 million.

Nov. 9 2001- Dynergy offers to buy Enron for $10 billion.

Nov. 28 2001- Dynergy refuses to buy Enron.Dec. 2 2001- Enron Files for Bankruptcy.June 2002- Arthur Anderson is convicted of

obstruction of justice and loses its auditing

The Motivation Enron delivered smoothly growing earnings (but not cash flows.) Wall

Street took Enron on its word but didn’t understand its financial statements.

It was all about the price of the stock. Enron was a trading company and Wall Street normally doesn’t reward volatile earnings of trading companies. (Goldman Sacks is a trading company. Its stock price was 20 times earnings while Enron’s 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.”

Enron’s Corporate Strategy Was devoid of any boundary system Enron’s core business was losing money—shifted 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, Enron’s derivatives-related assets increased from $2.2 billion to $12 billion and derivates-related liabilities increased from $1.8 billion to $10.5 billion

Enron’s 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.

“Value at Risk (VAR)” MethodologySome warning signs disclosed by Frank Portnoy before January 24, 2002 Senate

Hearings

Enron captured 95% confidence intervals for one-day holding periods—didn’t disclose worst case scenarios

Relied on “professional judgment of experienced business and risk managers” to assess worst case scenarios

Investors didn’t know how much risk Enron was taking Enron had over 5,000 weather derivatives deals valued at over $4.5 billion—

couldn’t be valued without professional judgment From the 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 Management—that employed “rocket Scientists” and Nobel laureates to design sophisticated computer models, Enron’s statement that it would “refine” its own models should have raised concerns

Special Purpose Entities (SPEs) (Enron’s principal method of financial statement fraud involved the use of SPEs)

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

Enron’s 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 management—Blockbuster 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 was not put on financial statements of

Enron) To manipulate cash flows, especially in 4th quarters Many SPE transactions were timed (or illegally back-dated) just near

end of quarters so that income could be booked just in time and in amounts needed, to meet investor expectations

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%) 1984—”EITF 84-15” Grantor Trust Consolidations

(Permitted non-consolidation if owned more than 50%) 1990—”EITF 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.

The Famous “Misleading Earnings Release” on October 16, 2001 Headline: “Enron Reports Recurring Third Quarter

Earnings of $0.43 per diluted share…” Projected recurring earnings for 2002 of $2.15 If you dug deep, you learned that Enron actually lost

$618 million or $0.84 per share—they 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 shareholder’s equity, including what was described as a $1 billion correction to an accounting error. (This was learned a couple of days later.)

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

consulting services. Failed to spot many of Enron’s losses Should have assessed Enron management’s internal controls on

derivatives trading—expressed approval of internal controls during 1998 through 2000

Kept a whole floor of auditors assigned at Enron year around Enron was Andersen’s second largest client Provided both external and internal audits CFOs and controllers were former Andersen executives Accused of document destruction—was 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.

Role of Law FirmsEnron’s outside law firm was paid substantial

fees and had previously employed Enron’s general counsel

Failed to correct or disclose problems related to derivatives and special purpose entities

Helped draft the legal documentation for the SPEs

Role of Credit Rating AgenciesThe three major credit rating agencies—Moody’s,

Standard & Poor’s and Fitch/IBCA—received substantial fees from Enron

Just weeks prior to Enron’s bankruptcy filing—after most of the negative news was out and Enron’s stock was trading for $3 per share—all three agencies still gave investment grade ratings to Enron’s 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

So Why Did Enron Happen? Individual and collective greed—company, its employees,

analysts, auditors, bankers, rating agencies and investors—didn’t 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 practices—lack of transparency in

reporting financial affairs Unduly aggressive earnings targets and management

bonuses based on meeting targets Excessive interest in maintaining stock prices

Since these events have taken place, many changes have come about within the accounting industry.

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 dealt with the record retention policies of accounting firms.

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.

SAS 98 makes a lot of revisions and amendments to previous statements. 

These changes include changes to the relationship between GAAS and quality control standards, and audit risk and materiality concepts in audits.

SAS 99 outlines what fraud is, reaffirms the auditor’s 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 Enron’s books, where fraud existed.

The biggest change that accounting firms made was a move made by the four remaining members of the big five, KPMG, Ernst and Young, Deloitte, and PricewaterhouseCoopers. 

These four companies decided to break all ties with Andersen in an attempt to avoid being dragged into the Enron scandal. 

This scandal also caused many major companies who used Andersen as their auditor to hire auditors to double check all of the audit work that could be double checked. 

This cloud of doubt also extended to companies that Andersen gave qualified audit reports or consulting advice to.

The government reacted aggressively when they became aware of the Enron scandal- Congress and the SEC introduced legislation and proposals to deal with such situations. 

President Bush even announced one post-Enron plan.  This plan was to make disclosures in financial statements more informative and in the management’s letter of representation.  This plan would also include higher levels of financial responsibility for CEOs and accountants.

By far the biggest change brought about is the Sarbanes-Oxley Act which requires companies to re-evaluate it’s 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 and to affirm the fact that they don’t know of any fraud being committed by the company

These events have also allowed the world of academia to make many influential changes to curriculums, without adding or dropping classes. 

These changes include a new emphasis on accounting ethics and on special purpose entities.

Another big change that came from the Enron bankruptcy filing was a new push to separate auditing services from consulting services.

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The three new SAS presented earlier will help to expose fraud and deception where it exists in a company. 

The move by many businesses to hire new auditors allows the public to see that companies do care that they do not misrepresent their position to the public.

The governmental changes had the farthest-reaching effect of all the changes that would result from the Enron/Anderson debacle.

The changes in academia will produce a new kind of accountant.  The new accountants will have more training in ethics.

The Sarbanes-Oxley Act will drastically improve the accounting industry in two ways.

1.First it creates a lot more work for many of the public companies.

2.The second way is that it requires tougher restrictions on internal audits and in judging how well the internal audit is conducted.

The separation of auditing and consulting will move the accounting industry forward a great distance toward increased credibility.  It will decrease the occurrence of non-independence by auditors.  At the same time, this will allow companies to reap the benefits of having both auditors and consultants.

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Executives at Arthur Andersen and Enron did not set out to have a positive impact on the accounting industry or any industry.  They set out to make as much money for themselves as quickly as possible.  They were willing to do whatever it took to make that money.  These thoughtless acts and greed led both companies to an eventual downfall in bankruptcy.  However, the accounting industry reacted by introducing changes that would, in the long run, improve itself and the economy in which it exists.  The changes that are a response to the Andersen/Enron debacle may be coming to an end.  We are probably seeing the last laws, pronouncements, and statements that are a direct result of these actions.  Still, the changes that have occurred leave the accounting industry and the economy stronger.  Will the industry ever be perfect?  Probably not, but accountants and the world must continue to strive to make it as functional as it can be.  Only by this continued striving can the industry be good enough to function effectively and even thrive.