Analysis of Enron‘s Aggressive Accounting Methods Auditing | Ing. Oleksandra Lemeshko Lukas Müller America‘s most Innovative Company Agenda •Introduction in the case •Key facts about Enron •Usage of SPE •Clarifying the questions 1.Responsible parties of the Crisis of Confidence 2.Meanwhile prohibited accounting services 3.Vialotion of auditing standards? •Conclusion •Discussion 2 Lukas Müller | Auditing | September 30, 2016 Furthermore, Anderson destroyed valuable documents for the investigation of the affair Enron‘s claim to fame •Business: Energy and Internet services •Revenues in 2000: $ 100bn •Operating income: $ 1.3bn •Seven biggest US-American corporation •Largest corporate bankruptcy at that time in the US •Awarded as „America‘s most innovative Company“ for six Years in a row Introduction in the Case 3 Lukas Müller | Auditing | September 30, 2016 Source: Enron (2001), no author (n.d.) Furthermore, Anderson destroyed valuable documents for the investigation of the affair Restatements lead to a free fall of stock value •October 16: correction of balance sheet entries • •November 08: restatement of earnings from the last 5 years • •December 02: bankruptcy Introduction in the Case -$ 1.2bn - - - - -$ 600m - - - - - -$ 60bn 4 Lukas Müller | Auditing | September 30, 2016 Furthermore, Anderson destroyed valuable documents for the investigation of the affair Restatements lead to a free fall of stock value •October 16: correction of balance sheet entries • •November 08: restatement of earnings from the last 5 years • •December 02: bankruptcy Introduction in the Case -$ 1.2bn - - - - -$ 600m - - - - - -$ 60bn 5 Lukas Müller | Auditing | September 30, 2016 Furthermore, Anderson destroyed valuable documents for the investigation of the affair Enron abused a leak in the regulation system for (debt) financing •Principals of Enron‘s SPE •3% of the SPE‘s capital was contributed by independent firms •97% were guaranteed by loans, collateralized with Enron‘s stock •No need for integration in consolidated reports • •Applications •Debt financing without (own) debt •Squeezing profit out of misinvestments Introduction in the Case SPE creditor 97% loans stock (securities) $ independent firm 3% investment 6 Lukas Müller | Auditing | September 30, 2016 SPE organized as limited partnerships Enron abused a leak in the regulation system for (debt) financing •Principals of Enron‘s SPE •3% of the SPE‘s capital was contributed by independent firms •97% were guaranteed by loans, collateralized with Enron‘s stock •No need for integration in consolidated reports • •Applications •Debt financing without (own) debt •Squeezing profit out of misinvestments Introduction in the Case SPE creditor 97% loans stock (securities) $ independent firm 3% investment assets 7 Lukas Müller | Auditing | September 30, 2016 SPE organized as limited partnerships Task 1: Which parties were most responsible for the crisis of confidence? • •Enron •Andersen •Regulatory Institutions •Others Task 1: Crisis of Confidence 8 Lukas Müller | Auditing | September 30, 2016 Furthermore, Anderson destroyed valuable documents for the investigation of the affair Various layers supported dubious practices at Enron •Management/board/CEO encouraged agressive accounting (SPE or mark-to-market) •Accountants, esp. CFO A. Fastow who mainly organized the SPE •Focus on short-term success instead of sustainable growth •All employees like Watkins who should have acted against dubious practices Task 1: Crisis of Confidence 9 Lukas Müller | Auditing | September 30, 2016 Sherron Watkins wrote the letter to Lay Anderson issued unqaulified opinions for 15 years •“In our opinion, the financial statements […] present fairly, in all material respects, the financial position of Enron Corp. and subsidiaries […], in conformity with accounting principles generally accepted in the United States.” • Arthur Andersen LLP in the Enron Annual Report 2000 - Task 1: Crisis of Confidence 10 Lukas Müller | Auditing | September 30, 2016 Source: Enron (2001) Furthermore, Anderson destroyed valuable documents for the investigation of the affair Andersen‘s behaviour harmed the image of its sector, because •The “conscience of the industry” did not make the aggressive accounting and disclosures transparent •It focused to increase turnover through consulting instead of ensuring fair presentation •It shredded documents which were relevant to the SEC investigation of the Enron case •It should have dropped Enron as a client instead of helping them keeping the SPE system alive Task 1: Crisis of Confidence 11 Lukas Müller | Auditing | September 30, 2016 David Duncon (lead director to Enron) How independent was Andersen? •Enron was Andersen‘s second biggest client •Partnership lasted for 15 years •Andersen had an office at Enron‘s HQ •Andersen charged ca. $ 1m a week Task 1: Crisis of Confidence 12 Lukas Müller | Auditing | September 30, 2016 Furthermore, Anderson destroyed valuable documents for the investigation of the affair How independent was Andersen? •Enron was Andersen‘s second biggest client •Partnership lasted for 15 years •Andersen had an office at Enron‘s HQ •Andersen charged ca. $ 1m a week •Half of the fees resulted out of consulting services Task 1: Crisis of Confidence 13 Lukas Müller | Auditing | September 30, 2016 Furthermore, Anderson destroyed valuable documents for the investigation of the affair Regulators did not close the gap to prohibit the aggressive accounting •SEC or FASB should have acted against the foul quasi-subsidiaries of Enron •à Obligation to integrate them in the consolidated financial statement • •The permission for Enron to applicate the mark-to-market method should have been withdrawn after its excessive use • •Stricter control of Andersen‘s independence would have been necessary Task 1: Crisis of Confidence 14 Lukas Müller | Auditing | September 30, 2016 Permission for m2m in 1992 in long-term contracts in gas& elec  expand Who else could be responsible? -Investors and creditors who contributed the SPEs‘ capital -… Task 1: Crisis of Confidence 15 Lukas Müller | Auditing | September 30, 2016 Furthermore, Anderson destroyed valuable documents for the investigation of the affair The Sarbones-Oxley Act strenghtens the auditors‘ regulations •Henceforth, auditors are prohibited to 1.conduct internal bookkeeping •à The accounts would be managed and audited by the same firm. 2.do management consulting services •à Deep involvement in the client’s processes reduces mental independence 3.Conduct valuation and appraisal services •à Auditor’s has power and interest in a good client performance •for their auditing clients. Task 2: Meanwhile Prohibited Consulting Services 16 Lukas Müller | Auditing | September 30, 2016 Source: SEC (2013) After Eron scandale, PCAOB, Public company accouting oversee board Andersen‘s violations discovered in the Power Report -No complete disclosure of mistakes (p.17), instead hiding transaction in the footnotes (p. 202) -Lack of objectivity (p.132) -Helped to structure the SPEs instead of disclosing them (p.24, 132) -Neglected the risks of material misstatement of the financial statements (p.126) -No issuance of an adverse audit opinion -Lack of real and perceived independence - •à Assurance engagement did not enhance the degree of confidence Task 3: Violation of Auditing Standards 17 Lukas Müller | Auditing | September 30, 2016 If unqualified/clean opinion: „ Compliance: adequate disclosures have been included in the footnotes and other parts of the financial stm“ No circumstances requiring an explanatory paragraph Doubt about going concern (disclaimer) Departure from promulgated acci principles Reports [should] involve other auditors from SPEs Materiality, need for extra wording Enron could not keep up with the required pace of growth -Enron‘s exponential growth ended in a buble -The Enron case showed the necessity of effective regulation in liberal markets -The independence of auditors has to be guaranteed - - Conclusion 18 Lukas Müller | Auditing | September 30, 2016 Please rate the following statements •Joseph Beradino (Andersen CEO): „at the end of the day, we do not cause companies to fail.“ •„The revenues from consulting services are necessary to hire excellent professionals for the auditings.“ Discussion 19 Lukas Müller | Auditing | September 30, 2016 Furthermore, Anderson destroyed valuable documents for the investigation of the affair References •Enron (2001) „Enron Annual Report 2000“. Retrieved September 27, 2016 from http://picker.uchicago.edu/Enron/EnronAnnualReport 2000.pdf. Enron, Houston •Knapp, M. (2012). „Auditing Cases – International Edition“. Case 1.3 Enron Corporation. South-Western College Publishing, Nashville •No author (n.d.). „Enron Historical Stock Price“. Retrieved September 27, 2016 from http://law2.umkc.edu/faculty/projects/ftrials/enron/ enronstockchart.pdf •SEC (2013). „Strengthening the Commission‘s Requirements Regarding Auditor Independe“. Retrieved September 27, 2016 from https:// www.sec.gov/rules/final/33-8183.htm. US Securities and Exchange Commission, Washington D.C. 20 Lukas Müller | Auditing | September 30, 2016 Furthermore, Anderson destroyed valuable documents for the investigation of the affair AA vialotion by phase •1. Client acceptance •Ethical requirements not met •2. planning •Risk of missstatement was not concidered enough •Response to the identified risk not strong enough •3. Testing and evidence •Search for unrecorded liabilities •4. evaluation and evidence •Review financial stm and other report material • 21 Lukas Müller | Auditing | September 30, 2016