Auditing issues in Enron

Independent

Needed for the Houston office of Andersen, an audit partner that understands the role of being a “public watchdog” with “ultimate allegiance to the creditors and shareholders” . Arthur Anderson abandoned its roles as independent auditor by turning a blind eye to improper accounting, including the failure to consolidate, failure of Enron to make $51million in proposed adjustments in 1997, and failure to adequately disclose the nature of transactions with subsidiaries . Another example is Lord Wakeham joined Enron as a non-executive director in 1994 and also sat on Enron’s audit and compliance committee. In addition, Andersen also provides internal audit service to Enron, which in fact impact Andersen independence.

Regarding to Enron collapse, the regulatory environment in which the auditing profession operates must be restructured. According to Ramsay report, the audit independent supervisor board should be established to monitor audit firms’ processes, and monitor compliance with non-audit service fee disclosure and the audit committee should monitor the auditor’s independence and effectiveness.

True and fair view

With regard to issues arising from SPE, Raptors were not hedges in the economic sense of transferring risk to a third party, but rather a means of absorbing losses with a reserve of Enron shares contributed by the hedging entity. However, Anderson approved Enron not to consolidate Raptor because Raptor is defined as SPE that means Andersen had seriously breached the true and fair criterion.

Enron avoid to put pressures on balance sheet by means that issuing shares would go to an affiliate and then go to the public, the cash of which would come back to Enron by paying off the note or related receivable. For example, Enron sold inventory or assets of some sort in 1999 to an affiliated entity and received a promise to pay for those assets from that affiliate.

In general, Arthur Andersen misunderstood the nature of auditor independence and true and fair view is only perceived to form audit report in accord with the accounting standards.

2 Special purpose entity

According to concept of Special purpose entity, outside owners must make a ‘substantial’ investment (normally 3% of total capital), and their investment must actually be at risk. Second, the outside owners must have some control over the investment the entity. In accordance with FASB, SPE is not necessary to be consolidated. Therefore, Enron employed its advantage to transfer its risk to SPE (for example Chewco and Raptor) by reducing its liabilities or debts, which is favored by financial analyst and credit agencies.

In application the concept of SPE in Australian, SPE must be consolidated with its parent company. According to AASB 1024.23, those internal transactions including debts, investments and financial leasing, etc should be eliminated in full because those entities are comprised in Enron group.

Regarding to SPE character, the application of SPE includes tax advantage and reduce the cost of borrowing. However, Enron shift its risk to another party and mask of Enron’s debt position.

3 Guarantees in Enron Case

The role guarantees play in group structure

At the forefront of new business ventures and technology, Enron diversified into trading non-energy- related commodities- including new weather derivatives. Its investments resulted in a complex group arrangement with hundreds of subsidiary and other related entities, including Special Purpose Entities. The guarantees is a way to help the SPEs to “hedge” the market value of some of Enron’s investments, enabling it to transfer the losses off of its books.

The role guarantees play in collapse of Enron

Enron guaranteed hundreds of millions of dollars’ worth of the SPEs’ debt. It used its own stock, stock in publicly traded subsidiaries and rights to future shares of Enron stock to support the SPEs’ value. It sometime would offer cash guarantees.

In a typical transaction, for example, Enron would transfer its own stock to an SPE’s value. The SPE, in turn, would hedge the value of a particular investment on Enron’s balance sheet, using the transferred Enron stock as the principle source of payment. When Enron’s stock price subsequently fell, the SPE’s value also fell, triggering the Enron guarantees, which guarantee payments in turn apparently further reduced Enron stock value, triggering additional guarantees.

Other guarantees would eventually buffet Enron. In the case of Braveheart, CIBC World Markets made a $115.2 million investment in return for a promise of nearly all of Enron’s profit from the venture for 10 years. What’s more, Enron agreed to repay CIBC its investment, if Braveheart failed to make money.

The role guarantees play in distributions to creditors

Any time an enterprise guarantees the indebtedness of another in material amounts, the enterprise must disclose the nature and amount of the guarantees in the notes to the financial statements. When Enron’s SPEs sought credit, the lenders often required that Enron guarantee the debt. On several occasions, Enron guaranteed amounts that various SPEs borrowed by promising to pay cash or to issue additional common shares to repay the debt if the market price of Enron’s common shares dropped under a set amount or if Enron’s bond rating fell below investment grade. While the notes to Enron’s financial statements disclosed guarantees of the indebtedness of others, Enron did not mention that its potential liability on those guarantees, which shared common debt repayment triggers, totaled $4 billion.

From the analysis above, this guarantees leave the creditors with the high risk in the case the Enron was in financial difficulty, or the share price fell down.

The impact on Accounting

Following the demise of Enron, the FASB on February, 13, 2002, decided to initiate a separate project on Accounting for Guarantees. In reaching this decision, the board noted that although guarantees are commonly found in situation involving the use of SPE, they are also found in non-SPE situations. The Board directed the staff to prepare an “interpretation” of existing rule FAS 5, Accounting for Contingencies, to address disclosure and accounting issues for a guarantor that issues a guarantee of the indebtedness of others or other forms of guarantees to benefit another entity.

In November 2002, the FASB released Interpretation No.45. Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (FIN 45). Under FIN 45, guarantors must recognize all guarantees issued or modified after December 31, 2002, as liabilities on their balance sheets at the inception of a guarantee. MBA members have been concerned about the potential impact of FIN 45 on the accounting treatment of their guarantees, particularly standard representations and warranties in their loan sale agreements.

4 Powers Report v Enron case

The Powers Report — the report of the Special Investigative Committee of Enron’s Board of Directors chaired by Dean Powers of the University of Texas Law School — describes a number of issues leaded to the Enron collapse, most specifically the difficult issues resulting from related party transactions. In addition, the Report also addresses other underlying problems, such as accounting practices, corporate governance, management oversight, public disclosure issues and auditor independence.

Related Party Transactions

The most troubling aspect of Enron’s collapse was the prevalence of significant related party transactions involving high-ranking officers of the company. The Report illustrates the dual dangers of these transactions. First, the officers involved in these transactions are tempted to enrich themselves at the expense of the company. Second, the transactions may provide short-term accounting benefits to the company that would not be available in arms-length transactions with third parties. Senior officers who are expected to monitor and control related party transactions may be motivated to ignore problems because of the short-term financial benefits to the company or because they may view a transaction as fair compensation to the affected employee.

Good corporate governance practices attempt to address these dangers through disclosure requirements and independent director review. In Enron’s case, both of these failed because Enron’s lawyers and accountants, and its independent directors, did not exercise the vigilance necessary in light of the significance of the transactions. In particular, the Report criticized the Enron Board and Audit Committee for their lack of oversight. It further criticized the Audit Committee for failing to obtain a better understanding of the accounting and economic aspects of the transactions.

Accounting Practices

Enron’s accounting practices were characterized in the Report as “beyond aggressive” and were certainly a major factor leading to its collapse. In connection with an audit committee’s review of accounting practices generally, the Report also demonstrates the need to probe more deeply into unusual transactions that occur late in a reporting period and generate positive accounting results.

The Report criticized the Enron Audit Committee and the entire Board for their failure to develop a more thorough understanding of Enron’s off-balance sheet financing, particularly given the significance of these arrangements to the company’s reported earnings and the related party nature of these arrangements.

Auditor Independence

Concerns over the independence of outside auditing firms arose well before the Enron scandal. The two principal concerns are (i) the provision of non-audit related services by audit firms, and (ii) the presence of former employees of the outside auditor on the internal accounting staff of the audit client. The Enron collapse further inflamed the concerns over auditor independence, as Arthur Andersen provided significant non-audit related services to Enron and numerous former Andersen accountants worked as employees of Enron.

5 Audit Strategy

Enron’s complex structure was far away from people’s imagination. This company was once ranked at the 7th place of top 500 in the world. As for such a giant company, whose business extended to several industries and continents in the world, it was almost impossible and very costly to trace each transaction. Therefore, a transaction-based audit strategy did not suit for Enron. Such a strategy would have a very high risk. Meanwhile, in Enron’s business, option and future were used very frequently, and many other new financial instruments were developed and applied into its business. Some of them were even difficult for professional analysts to understand thoroughly. Although until now, no evidence has been found to prove that Andersen involved in fraud behaviour in Enron’s collapse. But, Andersen, as the auditor, should be responsible for the financial reports they audited.

A tailored audit strategy should be carried out for Enron and other similar companies. The most effective strategy is to focus on the nature of complexities. Based on their complex company structure, complex business relationships, also complex financial instruments, auditors may apply different methods in different circumstances. Specialists can be employed by the audit firms to examine the operations of the business and to point out the weak points in the company’s structure. Nowadays, most companies do not only operate in one industry, therefore, it is necessary to segment their accounting practice and audit into different parts according to the nature of the business and apply different audit procedures on them. At the same time, Transactions related to new financial instruments should be examined by professionals before they are recorded into financial reports. And the professionals should make sure they are recorded correctly.

6 Audit Risk

Inherent risk would have been very high in Enron. Inherent risk is the risk existed in company itself. As we discussed above, Enron’s complex structure would have a high possibility that misstatements could occur. Its business relationships would also be an incentive that causes high inherent risk. At the same time, frequently use of financial instruments was the third reason. For example, it was sometimes quite confusing what should be recorded as revenue and what should be recognized as liabilities at a specific time.

Control risk was also very high in Enron. Top management was an important role in designing and implementing internal control system, which can reduce control risk. But, the fact was that, top management was the beneficiary of fraud behaviour. Then, how could the internal control system operate effectively in this situation?

High detection risk was also found in Enron. Because of the high possibility of inherent risk and control risk, it was even harder for auditors to detect problems in financial reports as well as in the companies’ structure and internal control system. This was what happened on Andersen. No evidence indicated it involved in the fraud, but at least it didn’t detect the fraud even it provided audit service for Enron since 16 years ago. Problems arose when there were no effective audit procedures. Also, Andersen was paid 52 million US dollars by Enron, which had made it more carelessly.

In conclusion, inherent risk, control risk and detect risk would have been very high in Enron. According to the audit risk formula, this would lead to a fact that total audit risk was also very high.

Reference:

Frank Clarke, Graeme Dean, Kyle Oliver, ‘Corporate Collapse-Accounting, Regulatory and Ethical Failure’ Second Edition (Cambridge University Press 2003)

Gurdarshan S.Gill, Graham Cosserat, Philomena Leung, Paul Coram, ‘Modern Auditing & Assurance Services’ John Wiley & Sons Australia, Ltd

Tran M, ‘Enron Scandal’ 31 January 2002, Guardian Newspapers Limited

Carney D, ‘Enron: The Morticians Move in’ 21 January 2002 McGraw Hill Companies – Business Week