In my opinion, the main critical factor in the case of Enron is manipulative accounting practices.

Enron and Arthur Anderson both manipulated the financial statements, over reported income and under reported expenses to make Enron seem like a profitable and secure company, when in fact that was not the case. They achieved this by way of the contributing factors of misrepresented S Es, !ark to !arket Accounting, and Arthur Andersen"s poor #udgment, and lack of independence in the success or failure of Enron.

S Es or Special urpose Entities, are traditionally used to limit an investor"s risk to a single venture of a company, and to prevent their exposure to the risk of the rest of the company"s practices or ventures.$ Enron began using S E"s to hide it%s dirty laundry. & 'nder normal circumstances, a company may exclude a S E from its own financial statements if an independent party has control of the S E, and if this independent party owns at least ( percent of the S E. )*+ Andrew *astow created shell corporations to act as investors in these S Es to make it appear that they were independent third parties, when in fact they were backed and secured by Enron stock or loans. It is without ,uestion that Enron controlled these S Es and *astow headed at least one. The debt and assets purchased from Enron as well as the losses reported by the S E, no longer needed to be reported or disclosed on Enron"s financial reports. Although ,uestions were raised in Andersen"s risk assessment meetings regarding Enron%s use of S Es, the lead partner for Anderson at on Enron assured them that everything was good,( and eventhough these S Es were material to the financial stability of Enron, the Andersen audit team left them out of their reports and audits.

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The !ark to !arket method of Accounting allows for a long0term contract to be signed, and at that time the present value of expected future payments can be recorded now as revenue, and the present value of the cost to fulfill the contract can be recorded now as expenses.1 This appropriatness of this method of accounting under any circumstances is hotly debated. Enron began using !T! in $22$. The difference between the estimated value of their contract and the amount Enron estimated it would pay to fulfill it%s part of the deal was regarded as profit by Enron when in fact, they might not ever supply anything. There is little doubt that the pro#ections of the long0term income were optimistic and inflated. *or example, in the deal with 3lockbuster, Enron recorded estimated profits of more than 4$$. !illion, based on expected future revenue. 5ess than a year later the deal was canceled with 6ero in revenue actually being earned.7

Arthur Andersen"s actions at Enron defied some of the fundamental principals of 8AAS. 9owever at the time 8AAS did not exist. ublic accounting was self regulated by the AI) A. Although the AI) A did issue Statements on Auditing Standards to provide guidance on audit conduct, there were no conse,uences for deviating from these standards and no conse,uences for bad behavior.: The Anderson Audit team managed to seemingly ignore them. They were not independent. In addition to Independent Audit services Arthur Andersen provided, consulting services tax services, and 1. personnel left Enron to work at Anderson on their internal audit services for Enron. That is the exact opposite of independence. Anderson%s team also failed to act with due professional care and professional #udgment. The Anderson staff were well aware of the ,uestionable use of S Es and inflations made by the use of !ark to !arket accounting and chose to allow it to continue, and knowingly allowed the misrepresentation the financial statements. ;hy wouldn"t they< They had a vested interest in Enron doing, and appearing to do well financially. Anderson billed Enron for 7.
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!illion dollars in &..$#ust before the collapse, more than half of that was from nonaudit services./

)ould it happen today<

In my opinion, no. As a direct result of the fraud and scandal at Enron, as well as other well publici6ed frauds, the 'nited States 8overnment passed the Sarbanes0+xley Act in &..&. SA=3+> established the )A+3 to provide oversight to public accounting firms. It also established standards for auditor independence, financial disclosures, and conflicts of interest. 3ut most importantly SA=3+> enacted criminal penalties and therefore conse,uences for breaking the rules they set forth. 9ad theses rules been in place at the time, I don%t believe Enron or Arthur Andersen employees could have run so freely amuck. That%s not to say they would have been ethical, or even honest, but the chances of them pulling off such a wide spread, all encompassing fraud without being detected would have been far smaller.

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?uestions@

$. After )arl 3ass was removed from the Enron account, he indicated to his boss that he did not believe Enron should have known about internal discussions regarding accounting and auditing issues. Ao you agree with 3ass% position< ;hy or why not<

I agree. The ignoring of 3ass% concerns #ust goes to show how not independent Arthur Andersen

was in respect to their Auditing duties to Enron. An independent firm should haveBwould have investigated bass% concerns, but instead they were dismissed and 3ass was vilified by Enron employees for not going with the flow.

&. )onsider the Sithe Energies contract described in the case. Aoes accounting for the contract provide an example of how Enron violated the revenue recognition principle< ;hy or ;hy not<

Absolutely. The =evenue =ecognition principle states that revenue is recogni6ed when it is reali6ed or reali6able and it is earned, regardless of when cash is received. Any money Enron received up front for the Sithe Energy contract should not have been recogni6ed as revenue until provided services in which it could earn the revenue. Therefore pre0selling a &. year contract for $27 million cubic feet of gas per day, should recogni6e revenue on a daily basis for the sale of gas, not the entire &. years up front such as Enron did.

(. )onsult paragraphs 10- of )A+3 Auditing Standards Co. $7. As an auditor, what type of evidence would you want to examine to determine whether Enron was inappropriately recording revenue from the Sithe Energies contract<

3ecause they operate in such a volatile market, I would have re,uired substantial evidence to prove that the contract would generate the revenue that Enron claimed it would. ;hich they would be unable to produce. I would also examine supporting evidence and documentation for actual expenses incurred in supplying gas, as well as documents and evidence supporting actual revenue received for selling the gas. I probably would have confronted !anagement regarding how reckless their choice of using !ark to market Accounting in such a volatile market. I would have suggested they immediately cease the practice, and only record the revenues and expenses as they are earned or incurred

respectively. 'pon signing of the contract Enron should not have reported a single cent in revenue or expenses.

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)onsult section &.( of SA=3+>. Ao you believe this provision of the law goes far enough<

That is, do you believe the Audit *irm itself Dand not #ust the partnerE should have to rotate off an audit engagement every five years< ;hy or why not<

I think it goes far enough by making the partner rotate off an engagement. I don%t think it%s necessary to re,uire firms to drop the client after 7 years, so long as there is a review of their work and #udgments they have made regarding long term clients. Sunlight is the best disinfectant, meaning that oversight and knowing that someone will be checking your work under a fine tooth comb is a pretty big deterrent to fraud. It%s also not fair to tell a firm that they can%t retain a client because you don%t trust them to be independent when they have not shown any #ust cause for the accusation. I also believe that every client is different, and having a firm that is familiar with not #ust your industry, but your actual business makes it easier to get audits done in a timely fashion. 9aving to show someone the tedious ins and outs of your daily operations every 7 years when you switch auditors, while necessary, would get old fast.