Appendix

Company Cases
The case readings have been developed solely as a basis for class discussion. The case readings are not intended to
serve as a source of primary data or as an illustration of effective or ineffective auditing.
Reprinted by permission from Jay C. Thibodeau and Deborah Freier. Copyright Jay C. Thibodeau and Deborah
Freier; all rights reserved.
Case A.1
Enron
Synopsis
In its !!! "nnual Report# $nron prided itself on having %metamorphosed from an asset&based pipeline and po'er
generating company to a mar(eting and logistics company 'hose biggest assets are its 'ell&established business
approach and its innovative people.)
*!
$nron+s strategy seemed to pay off; in !!!# it 'as the seventh largest
company on the Fortune ,!!# 'ith assets of -., billion and sales revenues of -/!! billion.
*!*
From /00. to !!!#
$nron+s revenues had increased by more than 1,! percent and ., percent per year# 'hich 'as unprecedented in
any industry.
*!2
3et# 4ust a year later# $nron filed for ban(ruptcy# and billions of shareholder dollars and retirement
savings 'ere lost.
$nron+s auditor during this period 'as "rthur "ndersen# 556. "ndersen 'as one of the five largest
international public accounting firms and 'as convicted of obstruction of 4ustice in connection 'ith shredding
documents related to the $nron audit. "nd although this conviction 'as overturned in !!, by the 7nited 8tates
8upreme Court# "ndersen+s decision to destroy evidence cast suspicion on 'hether "ndersen 'as trying to cover
*!
$nron !!! "nnual Report# p. 1.
*!*
Joseph F. 9erardino# Remar(s to 7.8. :ouse of Representatives Committee on Financial 8ervices# December /#
!!/.
*!2
9ala ;. Dharan and <illiam R. 9uf(ins# %Red Flags in $nron+s Reporting of Revenues and =ey Financial
>easures#) >arch !!*# pre&publication draft ?'''.ruf.rice.edu@Abala@files@dharan&
buf(insBenronBredBflagsB!2/!!*.pdfC# p. 2.
up any guilt related to a failure to perform its professional responsibilities.
Enrons First Few Years
In /0D,# $nron had assets along the three ma4or stages of the supply chain of natural gasE production#
transmission# and distribution. Fatural gas 'as %produced) from deposits found underground. The natural gas 'as
transmitted via pipelines# or net'or(s# of underground pipes# either directly to industrial customers or sold to
regional gas utilities# 'hich then distributed the gas to smaller businesses and customers. 8ome companies in the
industry had assets related to specific activities 'ithin the supply chain. For eGample# some companies o'ned
pipelines# but did not produce their o'n gas. These companies often entered into long&term %ta(e or pay) contracts#
'hereby they paid for minimum volumes in the future at prearranged prices# to protect against supply shortages.
In early /0D.# $nron reported a loss of -/2 million for its first year. "s a result# the company employed a
series of cost&cutting measures# including layoffs and pay freeHes for top eGecutives. $nron also started selling off
assets to reduce its debt. Fevertheless# $nron+s financial situation 'as still blea( in /0D1. That year# >oody+s
do'ngraded its credit rating to %4un( bond) status.
*!,
Impact of Significant Industry Change on Enron
$nron faced significant change in its industry environment due to the government+s decision in the mid&/0D!s to
deregulate the once&highly regulated industry. The government# 'hich had dictated the prices pipeline companies
paid for gas and the prices they could charge their customers# decided to allo' the mar(et forces of supply and
demand to dictate prices and volumes sold. "s part of this process# the government reIuired that pipeline
companies provide %open access) to their pipelines to other companies 'anting to transport natural gas# so that
pipeline companies 'ould not have an unfair competitive advantage.
*!.
Enrons Natural Gas ipeline !usiness
$nron adapted by providing %open access) to its pipelines# i.e.# charging other firms for the right to use them. It
also too( advantage of the ability to gain %open access) to pipelines o'ned by other companies. For eGample# in
/0DD# $nron signed a /,&year contract 'ith 9roo(lyn 7nion to supply gas to a plant being built in Fe' 3or(.
*!,
9ethany >c5ean and 6eter $l(ind# The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of
Enron ?Fe' 3or(E 6enguin ;roup# !!*C# p. /2.
*!.
6aul >. :ealy and =rishna 6alepu# %;overnance and Intermediation 6roblems in Capital >ar(etsE $vidence
from the Fall of $nron#) :arvard FJ> Research 6aper Fo. !K1# "ugust !!# p. 1.
9ecause 9roo(lyn 7nion 'as not connected to $nron+s pipeline system# $nron needed to contract 'ith another
pipeline company to transport the gas to 9roo(lyn 7nion. $nron 'as# therefore# assuming added ris(s related to
the transportation of the gas. The long&term nature of the contract 'as also ris(y because prices could rise to a
level that 'ould ma(e the contract unprofitable.
*!1
Enron Expands into Natural Gas "rading and Financing
$nron capitaliHed on the introduction of mar(et forces into the industry by becoming involved in natural gas
trading and financing. $nron served as an intermediary among producers 'ho contracted to sell their gas to $nron
and gas customers 'ho contracted to purchase gas from $nron. $nron collected as profits the difference bet'een
the prices at 'hich it sold the gas less the prices at 'hich it purchased the gas. $nron+s physical mar(et presence
?i.e.# o'ning the pipelines and charging a price for distribution that 'as proportional to the spot price of gas it
might purchaseC helped mitigate the ris( of a price increase of the gas it 'as purchasing.
*!D
In response to the problem of getting producers to sign long&term contracts to supply gas# $nron started giving
such producers cash up&front instead of the payment over the life of the contract. $nron then allo'ed for the
natural gas contracts it devisedL'hich 'ere Iuite compleG and variable# depending on different pricing# capacity#
and transportation parametersLto be traded.
Enron Expands #eyond Natural Gas
$nron decided to apply its gas&trading model to other mar(ets# branching out into electricity and other commodity
mar(ets# such as paper and chemicals. To accomplish its eGpansion strategy# $nron sought to pursue an %asset
light) strategy. $nron+s goal 'as to achieve the advantages of a presence in the physical mar(et# 'ithout the
disadvantages of huge fiGed capital eGpenditures. For eGample# in natural gas# $nron divested its assets related to
pumping gas at the 'ellhead or to selling gas to customers# and then set out to acIuire assets related to midstream
activities# such as transportation# storage# and distribution.
*!0
9y late !!!# $nron o'ned ,#!!! fe'er miles of
natural gas pipeline than 'hen founded in /0D,; in fact# its gas transactions represented ! times its eGisting
*!1
9ethany >c5ean and 6eter $l(ind# The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of
Enron ?Fe' 3or(E 6enguin ;roup# !!*C# p. *2.
*!D
Christopher 5. Culp and 8teve :. :an(e# %$mpire of the 8unE "n $conomic Interpretation of $nron+s $nergy
9usiness#) Policy Analysis# Fo. 21!# February !# !!*# p. ..
*!0
Christopher 5. Culp and 8teve :. :an(e# %$mpire of the 8unE "n $conomic Interpretation of $nron+s $nergy
9usiness#) Policy Analysis, Fo. 21!# February !# !!*# p. 1.
pipeline capacity.
*/!
In addition# $nron undertoo( international pro4ects involving the construction and management of energy
facilities outside the 7nited 8tatesLin the 7nited =ingdom# $astern $urope# "frica# the >iddle $ast# India#
China# and Central and 8outh "merica. $stablished in /00*# the $nron International Division did not adhere to
the asset&light strategy pursued by other divisions. $nron also eGpanded aggressively into broadband# the use of
fiber optics to transmit audio and video. "mong its goals in that business 'ere to deploy the largest open global
broadband net'or( in the 'orld.
*//
Enrons Changes to Accounting rocedures
"s a result of its change in business strategy# $nron made significant changes to several of its accounting
procedures. For eGample# $nron began establishing several %special purpose entities) in many aspects of its
business. " special purpose entity ?86$C is an entityLpartnership# corporation# trust# or 4oint ventureLcreated for
a limited purpose# 'ith limited activities and a limited life. " company forms an 86$# so outside investors are
assured that they 'ill only be eGposed to the ris( of the 86$ and its particular purpose# such as building a gas
pipeline# and not the ris(s associated 'ith the entire company. In addition# the 86$ also protects the investment of
outside investors by giving them control over its activities. If an 86$ satisfies certain conditions# it does not have to
be consolidated 'ith the sponsoring company.
Conditions for Nonconsolidation of SEs
" company is not reIuired to consolidate the asset and liabilities of the 86$ into those contained on its o'n
balance sheet# and it may record gains and losses on transactions 'ith the 86$# if t'o conditions are metE
/. "n o'ner independent of the company must o'n a %substantive) eIuity interest ?of at least * percent of the
86$+s assets# and that * percent must remain at ris( throughout the transactionC# and
. The independent o'ner must eGercise control of the 86$.
The * percent minimum eIuity o'ned by outside investors 'as created in /00! by $ITF 0!K/, and formaliHed
by F"89 8tatement Fo.+s /, and /2!. This standard represented a ma4or departure from typical consolidation
rules# 'hich generally reIuired an entity to be consolidated if a company o'ned ?directly or indirectlyC ,! percent
*/!
6aul >. :ealy and =rishna 6alepu# %;overnance and Intermediation 6roblems in Capital >ar(etsE $vidence
From the Fall of $nron#) :arvard FJ> Research 6aper Fo. !K1# "ugust !!# pp. 0K/!.
*//
Christopher 5. Culp and 8teve :. :an(e# %$mpire of the 8unE "n $conomic Interpretation of $nron+s $nergy
9usiness#) Policy Analysis, Fo. 21!# February !# !!*# p. 2.
or more of the entity.
*/
Consolidation rules for 86$s 'ere also controversial because a company could potentially
use an 86$ for fraudulent purposes# such as %hiding) debt or nonperforming assets by (eeping these items off its
o'n consolidated balance sheet.
$E%I and Chewco
In /00* $nron and the California 6ublic $mployees Retirement 8ystem ?Cal6$R8C formed an 86$# a -,!! million
,!K,! partnership they called Joint $nergy Development Investments 5imited ?J$DIC.
*/*
$nron 'as not reIuired to
consolidate the partnership 'ithin $nron+s financial statements because it did not o'n more than ,! percent of the
venture.
In /001# $nron offered to buy out Cal6$R8+ interest in J$DI. To maintain J$DI as an unconsolidated entity#
$nron needed to identity a ne' limited partner. $nron+s CFJ "ndre' Fasto' proposed that $nron form another
86$# named Che'co Investments ?after Star Wars character Che'baccaC# the bul( of 'hose eIuity investment
'ould come from third&party investors# to buy out Cal6$R8+s J$DI interest.
*/2
Chewcos Capital Structure
7nsuccessful in obtaining outside eIuity# $nron created a capital structure for Che'co that had three elementsE
/. -,! million unsecured subordinated loan to Che'co from 9arclays 9an( ?$nron 'ould guarantee the loanC;
. -/* million advance from J$DI to Che'co under a revolving credit agreement; and
*. -//., million in eIuity ?representing approGimately * percent of total capitalC from Che'co+s general and
limited partners.
*/,
Chewcos artners
>ichael =opper# an $nron employee 'ho reported to CFJ Fasto'# 'as the general partner of Che'co. The limited
*/
9ala ;. Dharan# %$nron+s "ccounting Issues K<hat Can <e 5earn to 6revent Future $nrons#) 6repared
Testimony 6resented to the 7.8. :ouse $nergy and Commerce Committee+s :earings on $nron "ccounting#)
February .# !!# pp. //K/.
*/*
J$DI 'as also a sly nod to the 8tar <ars films; CFJ "ndy Fasto'# 'ho devised the partnership# 'as a 8tar
<ars fan.
*/2
<illiam C. 6o'ers# Jr.# Raymond 8. Troubh# :erbert 8. <ino(ur# Jr# Report of n!estigation "y the Special
n!estigati!e #ommittee of the $oard of %irectors of Enron #orp.# February /# !!# p. 2*.
*/,
<illiam C. 6o'ers# Jr.# Raymond 8. Troubh# :erbert 8. <ino(ur# Jr# Report of n!estigation "y the Special
n!estigati!e #ommittee of the $oard of %irectors of Enron #orp.# February /# !!# p. 20.
partner of Che'co 'as an entity called 9ig River Funding 55C# 'hose sole member 'as an entity called 5ittle
River Funding 55C. =opper had invested -//,#!!! in 9ig River and -/!#!!! in 5ittle River but transferred these
investments to <illiam Dodson ?'ho allegedly may have been =opper+s domestic partnerC. "s such# =opper
technically had no o'nership interest in Che'co+s limited partner. The remaining -//.2 million 'as provided by
9arclays 9an( in the form of %eIuity loans) to 9ig River and 5ittle River.
9arclays reIuired 9ig River and 5ittle River to establish cash reserve accounts of -... million and that the
reserve accounts be fully pledged to secure repayment of the -//.2 million. J$DI# of 'hich $nron still o'ned ,!
percent# made a special -/... million distribution to Che'co# out of 'hich -... million could be used to fund the
cash reserve accounts.
*/.
6lease refer to Figure 2././ in 8ection 2# on page //2# for a visual depiction of the Che'co
transaction.
Andersens Audit of the Chewco "ransaction
$nron+s auditor "rthur "ndersen reIuested that $nron provide all the documentation in its possession relating to
the Che'co transaction. In its audit of the transaction# "ndersen revie'ed the follo'ingE
*/1
M The minutes of $nron+s $Gecutive Committee of the 9oard of Directors approving the transaction
M The -/* million loan agreement bet'een J$DI and Che'co
M $nron+s guarantee agreement of a -2! million from 9arclays to Che'co
M "n amended J$DI partnership agreement
M " representation letter from $nron and a representation letter from J$DI# each of 'hich stated that related
party transactions had been disclosed and that all financial records and related data had been made available to
"ndersen.
"ndersen received confirmation regarding the loan agreement from a Che'co representative. "ndersen also
reIuested that $nron provide documents relating to Che'co+s formation and structure. :o'ever# $nron told
"ndersen that it did not have these documents and could not obtain them because Che'co 'as a third party 'ith
its o'n legal counsel and o'nership independent of $nron.
*/D
"ndersen allegedly accepted this eGplanation and
only relied on the evidence it had been given.
*/.
<illiam C. 6o'ers# Jr.# Raymond 8. Troubh# :erbert 8. <ino(ur# Jr# Report of n!estigation "y the Special
n!estigati!e #ommittee of the $oard of %irectors of Enron #orp.# February /# !!# pp. 2DK,/.
*/1
Thomas :. 9auer# 6repared <itness Testimony at 8ubcommittee on Jversight and Investigations related to
%Financial Collapse of $nron Corp#) February 1# !!.
<hen the Che'co transaction 'as revie'ed closely in late Jctober and early Fovember !!/# $nron and
"ndersen concluded that Che'co 'as an 86$ 'ithout sufficient outside eIuity and that it should have been
consolidated into $nron+s financial statements. The retroactive consolidation of Che'co and the investment
partnership in 'hich Che'co 'as a limited partner decreased $nron+s reported net income by -D million ?out of
-/!, million totalC in /001# by -/** million ?out of -1!* million totalC in /00D# by -/,* million ?out of -D0*
million totalC in /000# and by -0/ million ?out of -010 million totalC in !!!. It also increased $nron+s reported
debt by -1// million in /001# by -,./ million in /00D# by -.D, million in /000# and by -.D million in !!!.
*/0
Enrons &se of 'ar()to)'ar(et Accounting
$nron also lobbied the 8$C about the use of mar(&to&mar(et ?>T>C accounting for its trading business# 'hich
allo'ed for the present value ?rather than the %actual value#) 'hich 'as used in its original natural gas businessC of
the stream of future inflo's and eGpenses under a contract to be recogniHed as revenues and eGpenses# respectively#
once the contract 'as signed.
In /00# the 8$C+s chief accountant# <alter 8cheutH# granted $nron permission to use >T> during the first
Iuarter of its fiscal year ended December */# /00. :o'ever# he also said that >T> could be used only in $nron+s
natural gas trading business.
*!
$nron+s chief financial officer# Jac( Tomp(in# 'rote bac( to 8cheutH informing
him that %$nron has changed its method of accounting for its energy&related# price&ris( management activities
effective January /# /00/ the cumulative effect of initial adoption of mar(&to&mar(et accounting# as 'ell as the
impact on /00/ earnings is not material.)
*/
$nron 'as the first company outside the financial services industry to
use >T> accounting.
*
*/D
Thomas :. 9auer# 6repared <itness Testimony at 8ubcommittee on Jversight and Investigations related to
%Financial Collapse of $nron Corp#) February 1# !!.
*/0
<illiam C. 6o'ers# Jr.# Raymond 8. Troubh# :erbert 8. <ino(ur# Jr# Report of n!estigation "y the Special
n!estigati!e #ommittee of the $oard of %irectors of Enron #orp.# February /# !!# p. 2.
*!
Robert 9ryce# Pipe %reams: Greed, Ego, and the %eath of Enron ?Fe' 3or(E 6erseus 9oo( ;roup# !!C# p.
.1.
*/
Robert 9ryce# Pipe %reams: Greed, Ego, and the %eath of Enron ?Fe' 3or(E 6erseus 9oo( ;roup# !!C# p.
.1.
*
9ala ;. Dharan and <illiam R. 9uf(ins# %Red Flags in $nron+s Reporting of Revenues and =ey Financial
>easures#) >arch !!*# pre&publication draft ?'''.ruf.rice.edu@Abala@files@dharan&
<hile the value of stoc( portfolios varied directly 'ith changes in stoc( prices# the value of natural gas
contracts 'ere harder to assess. They often reIuired compleG valuation formulas 'ith multiple assumptions for the
formulas+ variables# such as interest rates# customers# costs# and prices. These assumptions have a ma4or impact on
value and are related to long time periods# in some cases# as long as ! years.
Early Application of '"' Accounting* Sithe Energies Agreement
Jne of the earliest contracts for 'hich $nron employed >T> accounting 'as an agreement for $nron to supply
8ithe $nergies 'ith /0, million cubic feet of gas per day for ! years for a plant that 8ithe 'as planning to build
in Fe' 3or(. The estimated value of the gas to be supplied 'as -*., to -2 billion. 7sing >T># $nron 'as able to
boo( profits from the contract even before the plant started operating.
**
9efore >T># it 'ould have recogniHed the actual costs of supplying the gas and actual revenues received
from selling the gas in each time period. 7sing >T> meant that as soon as a long&term contract 'as signed# the
present !alue of the stream of future inflo's under the contract 'as recogniHed as revenues and the present !alue
of the eGpected costs of fulfilling the contract 'ere eGpensed.
*2
Changes in value 'ere recogniHed as additional
income or losses ?'ith corresponding changes to the relevant balance sheet accountsC in subseIuent periods.
*,
Enrons Expanded &se of '"' Accounting
"lthough the 8$C had initially given approval for $nron to use >T> in the accounting of natural gas futures
contracts# $nron Iuietly began using >T> for electric po'er contracts and trades as 'ell.
*.
In one eGample#
$nron signed a /,&year -/.* billion contract to supply electricity to $li 5illy. $nron calculated the present value of
the contract as more than half a billion dollars and recogniHed this amount as revenue. It also reported estimates
buf(insBenronBredBflagsB!2/!!*.pdfC# pp. 1K//.
**
9ethany >c5ean and 6eter $l(ind# The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of
Enron ?Fe' 3or(: 6enguin ;roup# !!*C# pp. .!K./.
*2
9ala ;. Dharan and <illiam R. 9uf(ins# %Red Flags in $nron+s Reporting of Revenues and =ey Financial
>easures#) >arch !!*# pre&publication draft ?httpE@@'''.ruf.rice.edu@Abala@files@dharan&
buf(insBenronBredBflagsB!2/!!*.pdfC# pp. 1K//.
*,
9ethany >c5ean and 6eter $l(ind# The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of
Enron ?Fe' 3or(E 6enguin ;roup# !!*C# p. *0.
*.
9ethany >c5ean and 6eter $l(ind# The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of
Enron ?Fe' 3or(E 6enguin ;roup# !!*C# p. /1.
for the costs associated 'ith servicing the contract. "t the time# Indiana had not yet deregulated electricity. Thus#
$nron needed to predict 'hen Indiana 'ould deregulate# as 'ell as the impact of the deregulation on the costs
related to the deal.
*1
$nron also eGtended >T> accounting to other businesses. In another eGample# $nron signed a !&year
agreement 'ith 9loc(buster Nideo in July !!! to introduce entertainment on&demand. $nron set up pilot pro4ects
in 6ortland# 8eattle# and 8alt 5a(e City to store the entertainment and distribute it over its broadband net'or(.
9ased on these pilot pro4ects# $nron recogniHed estimated profits of more than -//! million for the 9loc(buster
deal. Technical viability and mar(et demand 'ere difficult to predict in these initial stages.
*D
Canceled in >arch
!!/# the 9loc(buster deal never reached past the pilot stage# yet significant profits 'ere recogniHed by $nron on
the deal.
Enrons +elationship with Auditor Arthur Andersen
$nron paid "rthur "ndersen -2..D million in fees for auditing# business consulting# and taG 'or( for the fiscal
year ended "ugust */# /000; -,D million in !!!; and more than -,! million in !!/.
*0
"ndersen 'as collecting
a million dollars a 'ee( from $nron in the year before $nron+s cash. It 'as one of "ndersen+s largest clients.
>ore than half of that amount 'as for fees that 'ere charged for nonaudit services.
**!
In !!!# for eGample#
$nron paid "ndersen -, million for audit services and -1 million for consulting and other services# such as
internal audit services.
**/
"ndersen had performed $nron+s internal audit function since /00*. That year# "ndersen had hired 2! $nron
personnel# including the vice president of internal audit# to be part of "ndersen+s team providing internal audit
*1
6aul >. :ealy and =rishna 6alepu# %The Fall of $nron#) &ournal of Economic Perspecti!es# Nol. /1# Fo. #
8pring !!*# p. /!.
*D
6aul >. :ealy and =rishna 6alepu# %The Fall of $nron#) &ournal of Economic Perspecti!es, Nol. /1# Fo. #
8pring !!*# p. /!.
*0
"nita Raghavan# %"ccountableE :o' a 9right 8tar at "ndersen Fell "long 'ith $nron#) The Wall Street
&ournal, >ay /,# !!. "ccessed from Factiva ?February ,# !!,C.
**!
Jane >ayer# %The "ccountants+ <ar#) 'e( )or*er, "pril # !!. "ccessed from 5eGisFeGis "cademic
?February ,# !!,C.
**/
Fanette 9yrnes# %"ccounting in Crisis#) $usinessWee*, January D# !!. "ccessed from 5eGisFeGis "cademic
?February ,# !!,C.
services.
**
In !!!# as 8$C chairman "rthur 5evitt 'as trying to reform the industry practice of an audit firm also
offering consulting services to their audit clients# $nron+s Chairman and C$J =en 5ay sent a letter to 5evitt ?the
letter 'as secretly coauthored by "ndersen partner David DuncanC# in 'hich he 'roteE
<hile the agreement $nron has 'ith its independent auditors displaces a significant portion of the
activities previously performed by internal resources# it is structured to ensure that $nron management
maintains appropriate audit plan design# results assessment# and overall monitoring and oversight
responsibilities $nron has found its %integrated audit) arrangement to be more efficient and cost&
effective than the more traditional roles of separate internal and eGternal auditing functions.
***
"t "ndersen# an audit partner+s individual compensation depended on his or her ability to sell other services
?in addition to auditingC to clients.
**2
Therefore# the nonaudit services provided to $nron had a big impact on the
salary of the lead "ndersen partner on the $nron engagement# David Duncan# 'ho 'as earning around -/ million
a year.
**,
"fter graduating from TeGas "O> 7niversity# Duncan 4oined "ndersen in /0D/# made partner in /00,#
and 'as named the lead partner for $nron t'o years later. Duncan developed a close personal relationship 'ith
$nron+s Chief "ccounting Jfficer ?C"JC Richard Causey# 'ho himself had 'or(ed at "rthur "ndersen for almost
nine years. Duncan and Causey often 'ent to lunch together# and their families had even ta(en vacations
together.
**.
Causey# 'ho came to $nron in /00/# 'as appointed C"J in /001. Causey 'as responsible for recruiting many
"ndersen alumni to 'or( at $nron. Jver the years# $nron hired at least D. "ndersen accountants.
**1
8everal 'ere
in senior eGecutive positions# including Jeffrey >c>ahon# 'ho had served as $nron+s treasurer and president# and
**
Thaddeus :erric( and "leGei 9arrionuevo# %<ere "uditor and Client Too Close&=nitP) Wall Street &ournal#
January /# !!. "ccessed from 6roQuest Research 5ibrary ?February .# !!,C.
***
%5etter from =enneth 5ay#) 9igger than $nron transcript# Frontline, "ired on 6ublic 9roadcasting 8ervice on
June !# !! ?'''.pbs.org@'gbh@pages@frontline@sho's@regulation@congress@lay.htmlC.
**2
Jane >ayer# %The "ccountants+ <ar#) 'e( )or*er, "pril # !!. "ccessed from 5eGisFeGis "cademic
?February ,# !!,C.
**,
9ethany >c5ean and 6eter $l(ind# The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of
Enron ?Fe' 3or(E 6enguin ;roup# !!*C# pp. /2.K/21.
**.
8usan $. 8Iuires# Cynthia J. 8mith# 5orna >cDougal# and <illiam R. 3eac(# nside Arthur Andersen ?7pper
8addle River# FJE 6rentice :all# !!*C# p. .
Nice 6resident 8herron <at(ins.
"lthough "ndersen had separate offices in do'nto'n :ouston# Duncan and up to one hundred "ndersen
managers had a 'hole floor available to them 'ithin $nron+s headIuarters in :ouston.
**D
Duncan once remar(ed
that he li(ed having the office space there because it %enhanced our ability to serve) and to %generate additional
'or(.)
**0
"ndersen boasted about the closeness of their relationship in a promotional video. %<e basically do the
same types of things. <e+re trying to (inda cross lines and trying to# you (no'# become more of 4ust a business
person here at $nron#) said one accountant. "nother spo(e about the advantage of being located in $nron+s
buildingE %9eing here full&time year&round day&to&day gives us a chance to chase the deals 'ith them and
participate in the deal ma(ing process.)
*2!
In fact# "ndersen and $nron employees 'ent on s(i trips and too( annual golf vacations together. They played
fantasy football against each other on their office computers and too( turns buying each other margaritas at a local
>eGican restaurant chain. Jne former senior audit manager at "ndersen said that it 'as %li(e these bright gee(s at
"ndersen suddenly got invited to this really cool# macho frat party.)
*2/
SGs %isappro,al of Special urpose Entities and the Audit "eams +esponse
In /000# $nron+s CFJ# "ndre' Fasto'# spo(e to David Duncan about $nron+s plan to set up a special purpose
entity ?later called 5J>C# a financing vehicle used to access capital or increase leverage 'ithout adding debt to a
firm+s balance sheet. "fter the discussion 'ith Fasto'# Duncan as(ed for the advice of the 6rofessional 8tandards
;roup ?68;C.
" member of the 68;# 9en4amin Feuhausen# represented the group+s disapproval in an e&mail 'ritten to >r.
**1
9ethany >c5ean and 6eter $l(ind# The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of
Enron ?Fe' 3or(E 6enguin ;roup# !!*C# p. /2,.
**D
8usan $. 8Iuires# Cynthia J. 8mith# 5orna >cDougal# and <illiam R. 3eac(# nside Arthur Andersen ?7pper
8addle River# FJE 6rentice :all# !!*C# p. /..
**0
Rebecca 8mith and John R. $msh'iller# +, %ays: -o( T(o Wall Street &ournal Reporters .nco!ered the /ies
That %estroyed Faith in #orporate America ?Fe' 3or(E :arper9usiness# !!*C# p. D0.
*2!
9ethany >c5ean and 6eter $l(ind# The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of
Enron ?6enguin ;roup# !!*C# p. /2..
*2/
Flynn >cRoberts# %Ties to $nron 9linded "ndersen#) #hicago Tri"une, 8eptember *# !!. "ccessed from
Factiva ?February *# !!2C.
Duncan on >ay D# /000E %8etting aside the accounting# ?theC idea of a venture eIuity managed by CFJ is terrible
from a business point of vie'. Conflicts of interest galore. <hy 'ould any director in his or her right mind ever
approve such a schemeP) he 'rote.
*2
In addition# 68; 'as firmly against the idea of $nron+s recording gains on the sales of assets ?or immediate
gains on any transactionsC to the Fasto'&controlled special purpose entity. In response to the recording of gains#
Duncan 'rote in a June e&mail# %I+m not saying I+m in love 'ith this either 9ut I+ll need all the ammo I can get
to ta(e that issue on on your point /# ?i.e.# the 'hole thing is a bad ideaC# I really couldn+t agree more.) 3et#
Duncan later told >r. Fasto' that "ndersen 'ould sign off on the transaction# under a fe' conditions# one of
'hich 'as that >r. Fasto' obtain the approval of $nron+s chief eGecutive and its 9oard of Directors.
*2*
8hortly after# Carl 9ass# 'ho 'as promoted to 68; in December /000# raised concerns over the sale of some
eIuity options 'ithin the 5J> special purpose entity. 9ass 'rote to his boss John 8te'art in an e&mail# %This is a
big item and the team apparently does not 'ant to go bac( to the client on this. I thin( at a minimum the 6ractice
Director needs to be made a'are of this history and our opposition to the accounting.)
*22
:o'ever# the memo
Duncan+s team prepared to document the deal indicated that 9ass %concurred 'ith our conclusions.)
*2,
9ass continued to ob4ect to the 5J> transaction# 'riting in an e&mail to 8te'art ?9ass+s bossC in February
!!!# %This 'hole deal loo(s li(e there is no substance. The only money at ris( here is -/.D million in a ban(rupt&
proof 86$. "ll of the money here appears to be provided by $nron. %
*2.
Duncan+s team did not address 9ass+
concerns and# in fact# continued to misrepresent his vie's to the client.
In late !!!# Duncan as(ed 9ass for more advice on ho' best to account for four $nron 86$s (no'n as
Raptors. $nron 'anted to lump together the financial results for all the entities# so that the more profitable ones
could offset losses being garnered by others. 9ass opposed the idea. Fevertheless# Duncan later decided that
*2
"nita Raghavan# %"ccountableE :o' a 9right 8tar at "ndersen Fell "long 'ith $nron#) Wall Street &ournal#
>ay /,# !!. "ccessed from Factiva ?February ,# !!,C.
*2*
"nita Raghavan# %"ccountableE :o' a 9right 8tar at "ndersen Fell "long 'ith $nron#) Wall Street &ournal#
>ay /,# !!. "ccessed from Factiva ?February ,# !!,C.
*22
Carl $. 9ass# Internal $&>ail to John $. 8tuart# %8ub4ectE $nron Jption#) December /D# /000.
*2,
>i(e >cFamee# %Jut of Control at "ndersen#) $usinessWee* 0nline# >arch 0# !!. "ccessed from 9usiness
8ource 6remier database ?December */# !!2C.
*2.
Carl $. 9ass# Internal $&>ail to John $. 8te'art# %8ub4ectE $nron Transaction#) February /# !!!.
"ndersen 'ould %accept the client+s position#) 'ith some modifications.
*21
In February !!/# "ndersen held a routine annual ris( assessment meeting to determine 'hether to (eep
$nron as a client. 8ome partners raised concerns relating to ho' much debt $nron 'as not putting on its balance
sheet# Fasto'+s conflict of interest# and the lac( of disclosure in the company+s financial footnotes.
*2D
Duncan
reassured his fello' partners.
Carl 9ass 'as removed from the $nron account in >arch !!/. 9ass 'rote to 8te'art ?9ass+s bossC in an e&
mail# %"pparently# part of the process issue stems from the client ?$nronC (no'ing all that goes on 'ithin our
'alls on our discussions 'ith respect to their issues. <e should not be communicating 'ith the client that so and
so said this and I could not get this past so and so in the 68;. I have first hand eGperience on this because at a
recent $ITF meeting some lo'er level $nron employee 'ho 'as 'ith someone else from $nron introduced herself
to me by saying she had heard my name a lotLRso you are the one that 'ill not let us do something. .+I have also
noted a trend on this engagement that the Iuestion is usually couched along the lines R'ill the 68; support thisP+
<hen a call starts out that 'ay# it is my eGperience that the partner is struggling 'ith the Iuestion and 'hat the
client 'ants to do.)
*20
8te'art complained to a senior partner about 9ass+s removal. Duncan called >r. 8te'art
and eGplained that t'o $nron eGecutives# Richard Causey and John $chols# had pushed for 9ass+s removal.
*,!
Comprehensi,e -ist of Case .uestions
/. <hat is auditor independence and 'hat is its significance to the audit professionP <hat is the difference
bet'een independence in appearance and independence in factP
. 6lease consult 6aragraph * of 6C"J9 "uditing 8tandard Fo. . In 'hat 'ays# if any# 'as "rthur
"ndersen+s independence in fact or in appearance potentially impacted on the $nron auditP
*. Refer to 8ection !/ of 8JS. 6lease identify the services provided by "rthur "ndersen that are no longer
allo'ed to be performed. Do you believe that 8ection !/ 'as neededP <hy or 'hy notP
*21
"nita Raghavan# %"ccountableE :o' a 9right 8tar at "ndersen Fell "long 'ith $nron#) Wall Street &ournal#
>ay /,# !!. "ccessed from Factiva ?February ,# !!,C.
*2D
>imi 8'artH# Po(er Failure: The nside Story of the #ollapse of Enron ?Fe' 3or(E Doubleday# !!*C# pp.
*,K*..
*20
Carl $. 9ass# Internal $&>ail to John $. 8te'art# %8ub4ectE $nron#) >arch 2# !!/.
*,!
"nita Raghavan# %"ccountableE :o' a 9right 8tar at "ndersen Fell "long 'ith $nron#) Wall Street &ournal#
>ay /,# !!. "ccessed from Factiva ?February ,# !!,C.
2. 6lease refer to 8ection !* and 8ection !. of 8JS. :o' 'ould these sections of the la' have impacted the
$nron auditP Do you believe that these sections 'ere neededP <hy or 'hy notP
,. 6lease eGplain 'hy an accounting and auditing research function ?li(e "ndersen+s 68;C is important in the
operations of a C6" firm. <hat role does the function play in completing the auditP
.. 6lease consult 8ection /!* of 8JS. Do you believe that the $ngagement 5eader of an "udit ?li(e David
Duncan on the $nron auditC should have the authority to overrule the opinions and recommendations of the
accounting and auditing research function ?li(e the 68;CP <hy or 'hy notP Do you thin( that a 6C"J9
inspector 'ould approve of this practiceP
1. "fter Carl 9ass 'as removed from the $nron account# he indicated to his boss that he did not believe $nron
should have (no'n about internal discussions regarding accounting and auditing issues. Do you agree 'ith
9ass+s positionP <hy or 'hy notP
D. 6lease consult 8ection !* of 8JS. Do you believe that this provision of the la' goes far enough# that is# do
you believe the audit firm itself ?and not 4ust the partnerC should have to rotate off an audit engagement every
five yearsP <hy or 'hy notP
0. 9ased on your understanding of inherent ris( assessment# please identify three specific factors about $nron+s
business model in the late /00!s that are li(ely to impact your audit procedures if you 'ere conducting an
audit of the financial statements at $nron.
/!. 6lease consult Q*0 and Q2* of the 6C"J9 8taff Questions O "ns'ers ?>ay /.# !!,C. Comment about ho'
your understanding of the inherent ris(s identified at $nron ?in Question T/C 'ould influence the nature#
timing# and eGtent of your audit 'or( at $nron.
//. 6lease consult 6aragraphs T.D/1! of the 6C"J9 "uditing 8tandard Fo. . Consider ho' the change in
industry regulation and $nron+s resulting strategy shift 'ould impact your inherent ris( assessment for the
relevant financial statement assertions about the revenue account. 8pecifically# please eGplain 'hy your
understanding of $nron+s strategy impacts such inherent ris( assessment.
/. Consult 6aragraph T2 of 6C"J9 "uditing 8tandard Fo. and 8"8 Fo. 00. 6lease brainstorm about ho' a
revenue recognition fraud might occur under $nron+s strategy in the late /00!s. Can you thin( of a control
procedure that 'ould prevent# detect# or deter such a fraudP
/*. 6lease consult the (ey provisions of $merging Issues Tas( Force ?$ITFC 0!&/,. :o' did $nron+s Che'co 86$
fail to meet the outside eIuity reIuirement for nonconsolidationP Did $nron meet the %control) reIuirement
for nonconsolidationP
/2. 9ased on your understanding of the audit evidence# did "rthur "ndersen rely on sufficient and competent
audit evidence in its audit of the Che'co transactionP <hy or 'hy notP
/,. 6lease consult 8ection 2!/ of 8JS. :o' 'ould 8ection 2!/ apply on the $nron auditP Do you thin( that
8ection 2!/ 'ould have improved the presentation of $nron+s financial statementsP
/.. Consult 6aragraph T.! and 6aragraphs T.DK1! of 6C"J9 "uditing 8tandard Fo. . <hat is the relevant
financial statement assertion?sC about 'hich of the financial statement account?sC related to the Che'co
transactionP 6lease provide adeIuate support for your ans'er.
/1. 6lease consider the 8ithe $nergies contract described in the case. Does the use of >T> accounting violate the
revenue recognition principle of ;""6P <hy or 'hy notP
/D. 6lease refer to 6aragraph T1 of 6C"J9 "uditing 8tandard Fo. . "s an auditor# 'ould you consider the
natural gas trading revenue recogniHed using >T> accounting as having a %differing level) of inherent ris(
than other types of revenue recogniHed by $nronP <hy or 'hy notP
/0. Refer to 6aragraph T12 of 6C"J9 "uditing 8tandard Fo. . Can you identify one point in the natural gas
revenue recognition process 'here a member of $nron+s management team might be able to perpetrate a
fraudulent misstatement related to one of the relevant financial statement assertionsP 6lease identify the
assertion and use the case information to provide an eGample for your ans'er.
!. 6lease refer to 6aragraphs TD2KD, of 6C"J9 "uditing 8tandard Fo. . Identify one specific control activity
that could be designed to prevent the misstatement ?that you identifiedC from occurring. FeGt# identify one
specific control procedure that could be designed to detect the misstatement ?that you identified in Question
T*C from occurring.